Credible takeaways
- 401(k) loans are easier to get with bad credit, but you’ll miss out on growth in your retirement account, and you might have to repay the loan at once if you leave your job.
- Personal loans may offer higher borrowing limits and longer repayment terms than 401(k) plans.
- If you don’t repay a 401(k) loan according to your plan’s rules, you could get hit with a 10% tax penalty and owe income tax on the balance.
- If you don’t repay a personal loan according to your agreement, it could negatively impact your credit.
If you have a bigger expense than you can manage at once, whether that’s an expensive repair or a medical bill, a loan can help you pay for it over time. A 401(k) loan allows you to borrow against your retirement account, while a personal loan lets you borrow from a lender. Both options provide a lump sum of cash upfront in exchange for payments made over a set term.
To choose the best option, consider your borrowing needs, credit score, budget for repayment, and career plans. Here’s what you need to know to make the right choice.
401(k) loan vs. personal loan
How does a 401(k) loan work?
With a 401(k) loan, you can borrow some of the money in your retirement account and pay it off over time. Qualification generally isn't an issue as long as your plan's administrator allows loans and you have a vested account balance. And repayment is typically a streamlined process since payments are usually deducted from your paycheck. But there are risks to 401(k) loans that you should carefully consider before taking one out. More on all of this below.
How do you qualify for a 401(k) loan?
To qualify for a 401(k) loan, you must be an employee of a company that sponsors a 401(k) plan and allows loans for plan participants. You must have also contributed money to a 401(k) account, as your balance will determine how much you can borrow. There are no credit score or income requirements as with other loan types. If you are married, it’s possible your spouse may need to consent to the loan, but this is not common — check with your plan sponsor for details.
How much can I borrow from my 401(k)?
The IRS limits 401(k) loan amounts to $50,000 or 50% of the vested balance, whichever is less. However, some plans include an exception: If 50% of the vested balance is less than $10,000, then the account holder can borrow up to $10,000. Take a look at the following examples:
- Sara has $150,000 in her 401(k) account. She can borrow up to $50,000.
- Jim has $40,000 in his 401(k) account. He can borrow up to $20,000.
- Darcy has $16,000 in their account. They can borrow up to $10,000.
- Jane has $8,000 in her 401(k) account. She can borrow up to $8,000.
401(k) repayment rules and taxes
Typically, you’ll need to repay your 401(k) loan within five years, making payments at least once per quarter. There’s an exception to the time limit if you’re using the loan to buy your primary residence. There is generally no penalty for paying it off early, and doing so might give your money more opportunity to grow.
However, there is a repayment rule you should be aware of: If you leave your job, your plan might require that you pay the full balance upon termination of your employment. If you can’t come up with the funds, the loan will be treated as an early distribution, which will incur a 10% early distribution penalty if you were under 59 ½ when you took out the loan. You’ll also have to pay income tax on the balance, unless you’re able to roll the balance over to an eligible retirement plan.
Note: If you can show you have an “immediate and heavy” financial need, you can take a withdrawal from your plan instead of a loan, but only for the amount needed to cover it. This is known as a hardship distribution. It doesn’t need to be repaid, and you won't be charged a 10% tax penalty on the amount withdrawn. But you’ll still need to pay income tax (unless you made Roth contributions to your retirement plan). Taking a hardship distribution could also leave you with less money to spend during retirement.
How does a personal loan work?
A personal loan allows you to borrow from a lender and repay the loan over time. It typically doesn’t require you to put forth collateral, which is an asset the lender can take if you fail to repay, though some personal loans may still be secured. There are no potential tax consequences, like with a 401(k) loan, but qualifying for a personal loan can be difficult if you have bad or fair credit. Here’s what you need to know.
How do you qualify for a personal loan?
Personal loans have stricter eligibility criteria than 401(k) loans, though you won’t need a retirement account to qualify. You’ll typically need a FICO score of 670 or higher, with the best rates reserved for those with excellent credit. Some online lenders offer bad-credit personal loans, but these often come with higher borrowing costs.
Lenders also look at your annual income and existing debts. Some lenders may have minimum income requirements that borrowers must meet to be approved, as well as a maximum debt-to-income ratio (DTI) they will allow. Your DTI is the portion of your monthly income that you spend making minimum payments on your debts. While most lenders prefer a DTI under 35%, there are some who allow higher.
How much of a personal loan can I get?
Many lenders allow you to borrow up to $50,000, but some offer personal loans of up to $200,000 to certain applicants. The loan amount you’re ultimately approved for will depend on your credit profile and income. For example, if a lender sees you’re already paying off other debts, it may offer you a smaller amount.
Learn More: How Much of a Personal Loan Can I Get?
Personal loan repayment
You receive the funds from a personal loan as a lump sum and typically repay it in equal monthly payments over time. These payments include a portion of the principal, or the amount you borrowed, along with interest, which is the cost of borrowing the money. Over time, you’ll pay more than you borrowed for the privilege of getting the money upfront.
Learn More:
Important
To get a better sense of a loan’s cost, look at the APR. This includes the interest rate plus any upfront fees, such as origination fees, that could raise your cost of borrowing.
Which is better for bad credit?
For a 401(k) loan, neither your credit score or income are considered. All you typically need is a 401(k) plan that allows loans, and a vested balance in the plan. Plus, interest rates for 401(k) loans are not based on your credit score, and that interest is paid into your own account.
While you may be able to get a personal loan with bad credit, you’ll likely pay a higher rate. But there are many other factors to consider when choosing between a 401(k) loan and a personal loan, such as your retirement goals, career plans, and funding needs. Though it may be easier to get a 401(k) loan with bad credit, that doesn’t mean it’s best — especially if you expect to leave your job in less than five years.
Note
401(k) loan payments are typically taken out of your paycheck, so it’s unlikely you’d have the option of not making payments, and your take-home pay would be reduced proportionately.
If you’re having trouble qualifying for a personal loan — or are aiming for better terms — you could consider looking into secured loans or lenders that allow cosigners. Either could help you qualify or score a better rate. Just remember that taking out a secured loan means risking something as collateral, and the person who cosigns your loan would be responsible for payments should you miss them.
401(k) loan vs. personal loan FAQ
Can you repay a 401(k) loan early?
It depends on your employer’s rules, but in most cases, there is no prepayment penalty associated with a 401(k) loan. That means you can pay it off early and give your retirement funds more time to grow.
Who gets the interest on a 401(k) loan?
The interest on a 401(k) loan goes back into your retirement account. Essentially, you’re paying yourself interest. Just note that this may not compensate for gains you lost out on, on account of taking the loan.
If you leave your job, your employer may require you to repay the outstanding balance within a short time frame. If you can’t repay, the loan will become a taxable distribution plus a 10% penalty if you’re under 59 ½. However, there are a couple of ways to avoid this. It may be possible to roll over your outstanding balance into a new 401(k) plan that allows loans. If that doesn’t work, you can apply for a personal loan to cover the outstanding balance so you can avoid the penalty.
