Individuals often need cash to pay for items like a down payment on a new home, unexpected medical bills, or just simply to consolidate debt. Two common options to shore up money are tapping your 401(k) plan’s assets or taking out a personal loan. While neither choice is indicative of an ideal financial situation, there are advantages and disadvantages with both options that you should consider.
Financial advisors should be well-versed in assisting clients who need money to pay for unexpected bills or large one-off items. Cash flow planning is becoming a bigger piece of good financial planning. Helping an individual or couple analyze whether a 401(k) loan or a personal loan is a better choice can go a long way in building better relationships.
What is a 401(k) Loan?
A 401(k) loan is simply borrowing money from yourself. A participant pulls money from an employer’s 401(k) plan to pay for any number of items. You must then pay yourself back with interest. Workers must check with the employer as not all companies offer 401(k) loans. Plans that allow them might have unique requirements regarding what a participant can borrow. In general, however, individuals can request a loan of up to $50,000 or 50% of the account’s vested balance (whichever is less). The maximum term of a 401(k) loan is up to five years.
The upshot with 401(k) loans is that the money tapped can be used for almost any purpose. People commonly take out a 401(k) loan for home improvements, a down payment on a house, consolidating high-interest debt, paying off an unexpected medical bill, or even starting a business. It’s not free money, though. You must pay back the amount borrowed with interest, but the rate is often low versus other financing options. Repayment is often executed through payroll deductions with an employer.
Taking a 401(k) loan might not be ideal since you might forgo stock market gains. Moreover, the strategy is not optimal from a tax perspective as the interest repayment is subject to income tax. Unlike what some outlets report, though, the amount borrowed from a 401(k) does not face double taxation.
What is a Personal Loan?
A personal loan is more straightforward than the policies of a 401(k) loan. With a personal loan, you borrow money, typically from a bank, online lender, or credit union. It’s either an unsecured or collateralized form of borrowing. It is common for individuals who have high-interest credit card debt to opt for a personal loan to save on total interest costs.
A personal loan’s interest rate depends on a variety of factors including the amount borrowed, the borrower’s credit history, and the lender’s requirements. It’s a good rule of thumb for individuals with higher credit scores to take out personal loans since they will receive better interest rates.
401(k) Loan vs. Personal Loan: What’s Better for You?
Determining whether a 401(k) loan is better than a personal loan can be challenging, but a step-by-step approach can help you make the right call.
401(k) Loan Advantages and Disadvantages
A 401(k) loan might be the better choice for individuals with a low credit score and who have a sizable account balance. Borrowing from yourself sometimes features a more favorable interest rate and you should consider that you are repaying your future self, not a lender looking to score a profit. Also, keep in mind your credit score won’t be negatively impacted by an additional credit pull.
There are disadvantages to a 401(k) loan. At worst, the balance is treated as a taxable withdrawal (with a 10% early withdrawal penalty per the IRS) in the event you cannot repay the loan. More troubles come if you leave your employer since repayment is due as a lump sum. Finally, you might miss big stock market gains when you sell investments, so your opportunity cost could be significant.
Personal Loan Advantages and Disadvantages
A personal loan is a viable choice for those with high credit scores who can secure a favorable interest rate. Another upshot is that you can tailor the loan terms to your financial situation. Additionally, payback policies are often more flexible compared to the stringent rules of a 401(k) loan. Finally, there is no 10% early withdrawal penalty risk with a personal loan.
The downsides of a personal loan are considerable, however. They often feature high-interest rates which can dig people deeper into a debt hole. To make matters worse, there are often upfront fees and then prepayment penalties.
Individuals diligent about their finances might find a 401(k) loan a more attractive financing choice versus a personal loan. Every person’s situation is unique, though. That makes it even more important to work with an experienced financial planner who can recommend the right solution. Knowing the ins and outs of these two loan types can go a long way toward reducing risk and saving on interest costs.
Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. Before making major financial decisions, please speak with us or another qualified professional for guidance. The original version of this article first appeared on Wealthtender written by Mike Zaccardi.