Is a personal loan or a 401(k) loan better?
You may think that’s a strange question. Not many people weigh the differences between a personal loan or a 401(k) loan. That’s simply because those differences are so great.
A personal loan is almost always the better choice. The main exception to that is when nobody else will lend to you at least at a reasonable interest rate. With a 401(k) loan you’re effectively borrowing from yourself at a low rate. So nobody’s likely to run a credit check on you.
We’ll go into details about why borrowing from your 401(k) account is usually a bad idea. But first, let’s be clear what one of those accounts is.
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What is a 401(k)?
For a formal definition, you can check the IRS website. But here’s an overview.
A 401(k) account is a retirement fund. Your employer runs your plan and it deducts contributions from your paychecks.
Related: Top 12 reasons more people are using personal loans
Each 401(k) plan has its own rules. So sometimes you get a say over what investments your account makes. And sometimes your employer will make its own contributions to your account, perhaps even matching yours, dollar for dollar.
You may be allowed to borrow from your account. But that will depend on your plan’s rules. And there’s your first hurdle. You must check whether you can borrow at all.
When a 401(k) is a bad idea
Why does just about every financial adviser warn against borrowing from your 401(k) account? There are six main reasons:
- A sizable minority of Americans have no retirement savings. If you’re one of them, you won’t be able to raid yours.
- The money you borrow will no longer be invested. So you’ll miss out on some of the growth (maybe even a stock market boom) you’d otherwise have received.
- This is your retirement fund you’re messing with. You’ll need a very good reason to put your security in your senior years at risk.
- There can be significant tax implications for the interest you pay yourself.
- It’s harder to change jobs. If you can’t pay back the loan in full when you switch employers, you could face a big tax bill, plus early withdrawal penalties.
- Your 401(k) is protected if you become bankrupt. But you’ll reduce the amount that’s sheltered by the sum you borrow.
Phew! This is a step you don’t want to take lightly.
When a personal loan is a better idea
Taking a personal loan is a lot less “thrilling.” In fact, it’s positively vanilla and low-risk.
You borrow a lump sum over a fixed period and repay it in equal monthly installments. When you opt for a fixed-rate loan, every installment is the same.
If you choose a variable-rate one, they may go up and down a bit. If you follow interest-rate changes, you may think down more likely.
Quick, easy and affordable
And personal loans are quick to set up and affordable. Indeed, you’ll often pay little or nothing in setup costs. And interest rates are competitive with other forms of borrowing.
Your credit score will largely determine your rate. But it’s likely to be way lower than the one you’ll get on a new credit card.
Unsecured
Nearly all personal loans are unsecured. That means you don’t have to put up your home, car or any other asset as security or collateral.
If you want to borrow because you feel your finances are in a mess, this is a big plus. Let’s hope your loan doesn’t turn bad. But, if it does, your lender can’t immediately seize something you cherish.
*TheMortgageReports and/or our partners are currently unable to service the following states - MA, NV
When a 401(k) loan is your best bet
So we’re back to choosing between a personal loan and a 401(k) loan. With all those risks and downsides, how can the latter ever be better?
The only obvious situation is one in which you’re desperate and nobody else will lend to you. Or, if they will lend, they’re going to charge you a painfully exorbitant interest rate. Remember, your 401(k) plan’s administrators are unlikely to run a credit check on you before lending to you.
In fact, there are personal loan lenders who specialize in borrowers with poor credit. But, if even they won’t touch you, your 401(k) account may be your last resort.
How to get a personal loan: Step-by-step guide
Take care
But, even then, you want to take great care. If your finances are that dire, you may be close to bankruptcy. So don’t forget that the protections your 401(k) pot provides you against creditors will be reduced by the amount you’ve borrowed.
Desperation drives us all to make extreme choices. But don’t raid the fund that’s providing for your future security without first weighing your decision very carefully.
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*TheMortgageReports and/or our partners are currently unable to service the following states - MA, NV
