What Is a 401(k) Loan and Is it a good idea?

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What is an 401(k) Loan and Is it a good idea?
A 401(k) loan can derail your retirement savings. Weigh the risks and consider alternatives to financing.


Updated on January 31st, 2023

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Takeaways from Nerdy
The typical 401(k) plan allows you to borrow up 50% of your account balance for up to five years with a maximum limit of $50,000. The cost of borrowing is relatively low, and the interest paid is returned to the borrower. When you borrow money you are not able to benefit from potential gains on stocks and accruing interest that can increase your retirement savings. A 401(k) loan is best thought of after all other options have been exhausted.




Many 401(k) plans allow users to take out loans against their savings for retirement. It's a low-interest loan option that can be used to cover a large expense, but you should be careful. The process of getting a 401(k) loan can mean permanent retirement losses or even penalties if you're not able pay back the loan.
What is a 401(k) loan?
The rules of employers vary, however 401(k) plans generally permit users to borrow up to 50% of the balance of their retirement account or $50,000 -- whichever is less -up to a maximum of five years.
If other borrowing options have been not feasible then it's possible to take out a 401(k) loan might be an acceptable choice for paying off high-interest debt or to cover the cost of a necessity However, you'll need to follow an organized financial plan in order to repay it in time and stay clear of penalties.
Pros and pros and 401(k) loan
Consider the pros and cons prior to taking out a loan.
Pros
401(k) loans usually have one-digit interest rates, which makes them cheaper than credit cards. In general, interest is equal to one percentage point.
The interest you earn goes to your account.
There's not a credit check, and there's no an impact on the score of your credit.

Cons
It can derail pension savings often significantly.
If you decide to quit work, you must repay the loan quickly.
The risks include tax consequences as well as penalties.

The true cost of the 401(k) loan
If you take money from your retirement savings account will not benefit from market gains and the magic that is compound interest.
According to the report, borrowing $10,000 from a 401(k) plan for five years would mean sacrificing the investment return of $1,989 and ending the five years with a debt of less than $666. It is assumed that you pay 5% of the interest on the loan and the investments that are part of the plan would have yielded an average of 7%.
However, the expense to your retirement account doesn't stop there. If you have 30 years left until retirement, the unpaid $666 could have increased to $5,406, according NerdWallet's (assuming the same 7% return, compounding every month).
In addition, you could cut down on the amount of your 401(k) contributions while making payments on a loan taken out of the account. This will further decrease your retirement savings.
401(k) loans are tied to your company
If you leave your job and are still owing your 401(k) loan, you must pay the balance either in a single day or within shorter period. Some plans require immediate repayment in the event that you leave before the loan is fully paid.
If you're not able to repay the loan in full, your IRS will consider the unpaid amount a distribution and consider it the income you report on the tax year's return. You'll also incur an early withdrawal penalty if less than 59 1/2.
Do you want to use to take out a 401(k) loan to pay off your debt?
Before taking out the 401(k) loan to pay off debt, you should consider other options that won't impact saving for retirement.
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Debt consolidation lets you roll several high-interest debts onto a balance transfer card or personal loan with lower interest rates. There is a single monthly debt payment and less the total cost of interest.
Alternatives to debt relief If you're unable to pay off debts with no repayment options including credit cards as well as personal loans and medical expenses -- within five years, or if your total debt exceeds 50% of your income You may need to consolidate. The best solution is to talk with an attorney or credit counselor about , including credit counseling.
Bankruptcy: Chapter 13 bankruptcy and debt management plans require five years of payments minimum. After that, your remaining consumer debt will be eliminated. Chapter 7 bankruptcy discharges consumer debt immediately.
In contrast to consumer debt unlike consumer debt, the 401(k) loan isn't forgiven in bankruptcy.
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401(k) loan alternatives
Due to the risks that come the risk of 401(k) loans, first look at other financing options.
Alternatives for large expenses
Personal loans are a great option to use a for almost anything, from the consolidation of debt, home repairs emergency medical bills, and other expenses. The amount of loans ranges from $1,000 to $100,000, and rates range from 6% to 36 percent. They're usually repaid in monthly installments, over a period between two and seven years.
These loans are secured and therefore there is no collateral requirement. A lender uses information about your credit and financial history to determine if you're eligible as well as your loan's annual percentage rate.
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Find out if you're pre-qualified for personal loan - without affecting your credit score
Just answer a few questions to receive an estimate of your personal rate from a variety of lenders.


Loan amount
on NerdWallet








The home equity loans and credit lines The home equity loan or line of credit is a cost-effective way to cover urgent home repairs and other emergency. Depending on which you choose the best option, you could typically get as much as 80% your home's value, minus what you owe on your mortgage. Rates tend to be within the single digits, and repayment terms range from 10 to 20 years.
Home equity loans and credit lines require you to put up your home as collateral to secure the loan which means that the lender has the right to take it if you fail to repay. The biggest difference between these types of financing is their borrow-and repay structures.
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Transfer of balances at 0% APR credit card: Another option is to transfer high-interest debt onto a card with an interest-free promotional time. You typically need to have excellent credit to be eligible (690 or more credit score), and the amount you are able to transfer depends of the maximum credit amount the credit card company offers you. If you are eligible then you have to pay the balance in the interest-free promotional period -- usually 15 to 21 months to avoid paying the card's (often excessive) APR on a regular basis.
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Alternatives to pay for the smallest of costs
You can ask an amiable friend or family member to take out a loan to to bridge a gap in income or pay for an emergency. There's no credit checks when you use this method and you can draw up a contract with the lender that outlines the amount of interest charged and how the loan is to be paid back.
Cash advance applications let users borrow up to a few hundred dollars and pay it back when they next pay. These advances are a quick method to pay for a emergency expense. There's no need for interest, however, the apps typically add fees for fast funding and ask for optional tips.
If you're fixing a car or laptop, or buying a new mattress, the retailer may offer buy nowand pay later plans. This plan allows you to break up your purchase into smaller, generally biweekly installments. Having bad credit (a score less than 630) could not stop you from being eligible since there's typically only a credit check.
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About the writer: Annie Millerbernd is a personal loans writer. Her writing has been featured on The Associated Press and USA Today.







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