If you need to borrow money, a couple viable options could be a personal loan or borrowing against your 401(k) plan balance. This article will discuss the pros and cons of each and provide some guidance on weighing a personal loan vs 401(k) loan.
Personal loan vs 401(k) loan
For most people, the most readily available source of borrowing is a credit card. However, credit cards are a relatively expensive way to borrow.
At the other extreme would be a home equity loan. This could be a relatively cheap way to borrow because it uses equity in your home as collateral. However, not everyone has sufficient equity for a home equity loan, and you may also decide you don’t want to put your home at risk for this loan.
Personal loans and 401(k) loans can be considered as falling somewhere between these extremes. Personal loans are costly but generally cheaper than credit card debt. A 401(k) loan means borrowing against your retirement savings, but you may view this as less risky than borrowing against your home.
Personal loans and 401(k) loans each have their pros and cons, as will be outlined below. The right choice may depend greatly on your individual circumstances.
Personal loan pros and cons
- Cheaper alternative to credit card debt. According to Federal Reserve data, over the past ten years personal loan rates have averaged 10.35% while the average rate assessed on credit cards as been 14%. This means personal loans have had an average cost advantage of 3.65%.
- Fixed loan terms. Unlike a credit card, a personal loan will have a structured monthly payment and you will know going in how long it will take you to pay off the loan. This can help you budget and keep repayment on schedule.
- No hard-and-fast loan limit. The amount you can borrow is based on your financial means, not any legal limit.
- Approval depends on credit history and income. You should have a pretty strong credit record if you expect to qualify for a personal loan. Also, you should not have a high level of existing debt relative to your income.
- Cost may higher for some borrowers. Personal loan rates can be much higher than the average for borrowers who have shaky credit or borderline financial means. You might still get approved under those circumstances, but you should question whether a personal loan is still a cost-effective source of borrowing if your interest rate is much higher.
- Continuing payments can cramp future spending and saving. Borrowing always means trading future sacrifices in exchange for access to money now.
401(k) Loan: Pros and Cons
- Easy approval. Not all 401(k) plans allow participants to borrow against their balances, but if your employer’s plan does and you have a sufficient balance, approval should just be a formality.
- Low cost. Because your credit history and financial means don’t enter into the equation, you can expect to pay a relatively low interest rate on this kind of loan.
- You pay interest to yourself. While you are required to pay interest on a 401(k) loan, remember where that interest is going – into your own retirement plan balance. So, effectively you would be paying interest to yourself.
- Opportunity cost. Retirement programs generally depend on investment growth over time to magnify the amount of your contributions. When you borrow against your 401(k) balance, that money will be unavailable for investment until you pay it back. This could put your retirement plan behind schedule.
- Fees can be inefficient for small loans. 401(k) plans often charge set amounts for administering loans. These can represent a hefty percentage of smaller loan amounts, so you should factor that cost into your evaluation of this option.
- Tax penalty risk. If you leave your job, you will have to repay your 401(k) loan by the end of the next tax year. Failure to do this could result in the loan being deemed an unqualified distribution from the plan, which means you will owe both ordinary taxes on the balance plus a 10% penalty.
- Legal loan limits. The amount you can borrow from your 401(k) is limited by law. You generally cannot borrow more than half of your loan balance, though if you have less than $20,000 in the plan you can borrow up to $10,000 or the total amount of your balance, which ever is less. Besides these general legal limits, your specific plan may impose tighter limits.
Personal loan or 401(k) Loan: which is right for you?
Deciding whether to get a personal loan or a 401(k) loan depends very much on your circumstances.
The case for a personal loan is helped if you have an excellent credit history and a good income without a heavy burden of existing debt. These characteristics should increase your chances of getting approved for a personal loan and reduce the cost of that loan by allowing you to qualify for a better interest rate.
The case for a 401(k) loan is helped if you are confident in your job security and plan to stay with your employer for a long time. That would reduce the risk that you would have to pay the loan back early because you left your employer. It’s also a positive if your retirement balance is very well funded. That could help you afford to miss out on some investment earnings while you are borrowing the money and still keep your retirement plan on track.
In either case, a key to successful borrowing is to first think through how you will repay the loan. Understand what your payments will be and figure out how you will be able to afford them. Always budget before you borrow.