What is a 401(k) Loan and How Does it Work?

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Updated on Tuesday, May 24, 2016

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If you’re in need of money and your savings account balance is low, you may be tempted to use the handy little loan provision that most 401(k) plans offer. That’s right! You can probably borrow money from your 401(k). Right from your own account! It’s a nifty feature, but is it a good idea?

Today we’re going to start examining that question by diving into what exactly a 401(k) loan is and how it works. The next post in this series will look at a few situations in which borrowing from your 401(k) can work in your favor.

Let’s get into it!

Quick note: Every 401(k) plan has different terms and conditions and some plans don’t allow for loans at all. Consult your Summary Plan Description for specific details about how your plan handles loans.

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What Is a 401(k) Loan?

When you borrow from your 401(k) you are actually borrowing money directly from yourself.

The loan is taken directly out of your 401(k) account balance. Then a repayment plan is created based on the amount you borrowed and the interest rate and those payments are made back into your 401(k) account, typically through an automatic payroll deduction.

In other words, you are borrowing from yourself and paying yourself back. Both the principal and the interest on the loan eventually make their way back into your 401(k).

How Much Can You Borrow?

Figuring out how much you can borrow from your 401(k) can be a little tricky, but here’s a quick summary.

If you haven’t had any outstanding 401(k) loan balance within the past 12 months, you are allowed to borrow the lesser of:

  • $50,000, or
  • 50% of your vested 401(k) balance. If that amount is less than $10,000 then you can borrow up to $10,000, but never more than your total account balance.

Sounds simple, right? But wait, there’s more…

If you have had an outstanding 401(k) balance within the past 12 months, the amount you’re allowed to borrow is reduced by the largest balance you had over that period.

Let’s look at a few examples:

  • Example #1: Joe has $25,000 in his 401(k) and has not had a 401(k) loan balance within the past 12 months. He is allowed to borrow up to $12,500.
  • Example #2: Theresa has $15,000 in her 401(k) and has not had a 401(k) loan balance within the past 12 months. She is allowed to borrow up to $10,000.
  • Example #3: Becca has $150,000 in her 401(k) and has not had a 401(k) loan balance within the past 12 months. She is allowed to borrow up to $50,000.
  • Example #4: Steve has $25,000 in his 401(k) and did have a 401(k) loan balance of $5,000 within the past 12 months. He is allowed to borrow up to $7,500.

What Is the Interest Rate?

Each 401(k) plan is allowed to set their own loan interest rate. You should consult your Summary Plan Description or ask your HR rep for details about your specific plan.

However, the most common interest rate is the prime rate plus 1%.

What Can the Money Be Used For?

In many cases there are no restrictions on how you use the money. It can be put to work however you want.

But some plans will only lend money for certain needs, such as education expenses, medical expenses, or a first-time home purchase.

How Long Do You Have to Pay the Loan Back?

Typically, your 401(k) loan must be paid back within 5 years. If the loan is used to help buy a house, the term may be extended up to 10-15 years.

The catch is that if your employment ends for any reason, the entire remaining loan balance is typically due within 60 days. If you aren’t able to pay it back within that time period, the loan defaults.

What Happens If You Default on the Loan?

A 401(k) loan defaults any time you aren’t able to comply with the terms of the loan. That could be failing to make your regular payments or failing to repay the remaining loan balance within 60 days of leaving the company.

When that happens, the remaining loan balance is counted as a distribution from your 401(k). That has two big consequences:

  1. Unless you’re already age 59.5 or meet other special criteria, that money will be taxed and hit with a 10% penalty.
  2. The defaulted amount is not eligible to be rolled over into an IRA or other employer retirement plan. So there’s no way to avoid the taxes and penalty.

The good news is that the default is not reported to the credit bureaus and therefore has no impact on your credit score. Though if you’re applying for a mortgage or other loan, the lenders may ask about any 401(k) loan defaults and factor that into their decision.

How Do You Apply for a 401(k) Loan?

And as long as you have a vested 401(k) balance, the process loan application process is typically pretty simple.

Other than adhering to any specific restrictions your plan may enforce (see above), it’s usually as easy as requesting the loan. That can often be done online or at worst with a little paperwork through your human resources department.

There is no credit check for 401(k) loans, which can make them easier to get than other types of loans. And loans must be available to all employees, so you should be able to get approved no matter what your position is in the company.

Other Considerations

Here are a few other things to consider as you weigh the pros and cons of taking out a 401(k) loan:

  • Other than the possibility of default, the biggest potential cost is the missed investment returns while the money is out of your 401(k). Depending on the size of the loan and the market returns during the life of the loan, that could be significant.
  • Your spouse often has to sign off on the loan.
  • You can have more than one 401(k) loan out at a time, but the total loan balance can’t exceed the limits described above.
  • There may be a fee involved with taking out the loan.
  • Your loan payments do not count as 401(k) contributions, and your employer may or may not allow you to keep contributing to your 401(k) while your loan is outstanding.
  • Because the loan is not reported to credit agencies, a 401(k) loan is not a way to build your credit history or increase your credit score.
  • You typically cannot take a loan from a 401(k) you still have with an old employer.

Is a 401(k) Loan a Good Idea?

Those are the nuts and bolts of 401(k) loans, so is taking out a 401(k) loan a good idea? The answer is a definite maybe. There are times where it can be the best option, times where it’s a bad idea, and times where it can actually increase your overall investment return. Regardless, you should be sure to do a deep analysis and determine if you will definitely be able to pay the loan back in a timely manner before utilizing the 401(k) loan.

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