Personal Loan vs. 401(k) Loan: Who Gets the Interest?

The two tools side by side

A 401(k) loan is not credit from a lender. You take money out of your own retirement account and pay it back, with interest, through payroll deductions. A personal loan is money from a bank, credit union or online lender, priced on your credit file. The two can cost similar amounts each month and still leave you in very different places.

Not every plan offers loans: the IRS says a plan may, but is not required to, provide them. Some plans also require your spouse's written consent for a loan above $5,000. Your plan's summary plan description gives its rate, fees and rules.

The IRS rules for a 401(k) loan

• How much. The lesser of $50,000, or the greater of $10,000 or 50% of your vested account balance. With a $40,000 vested balance, the IRS example gives a maximum of $20,000. The $10,000 floor applies only if your plan allows it.
• How long. Repayment must be completed within five years. A loan used to buy your principal residence may be repaid over a longer period.
• How often. In substantially equal payments of principal and interest, at least quarterly. Most plans take them from each paycheck.
• If you miss payments. A defaulted loan is generally treated as a taxable distribution of the unpaid balance, a deemed distribution. A plan may allow a cure period that runs to the end of the calendar quarter after the quarter in which the payment was missed.
• The 10% additional tax. A distribution before age 59½ generally owes an additional 10% tax unless an exception applies, such as leaving your employer in or after the year you turn 55, total and permanent disability, or unreimbursed medical costs above 7.5% of adjusted gross income.

A worked example: $10,000 over three years

Say you need $10,000 to consolidate other debts and can repay over 36 months. Compare a 401(k) loan at 8.00%, the prime rate plus one point (your plan sets its own rate), with a 36-month personal loan at 11.90% and no fee.

On payments alone, the plan loan costs $659 less, and its interest lands in your account instead of a lender's. Both are paid from take-home pay. With the plan loan, that after-tax money goes into a tax-deferred account and, as FINRA puts it, will be taxed again when you eventually withdraw it. That second tax falls mainly on the interest portion, but it narrows the gap.

The cost you do not see: money out of the market

The $10,000 you borrow is sold out of your investments and comes back a little each month. Whether that helps or hurts depends on what those investments would have done, which no one knows in advance. The table shows a range of hypothetical yearly returns. These are illustrations, not forecasts.

The last column adds the $659 you save in payments by paying 8.00% instead of 11.90%. Returns compound monthly; taxes on later withdrawals and any change in your contributions are left out. When returns run above the plan's loan rate, the money you took out falls behind; when markets fall, borrowing from the account cushions the loss. Read the stock market and loan rates for how markets and borrowing costs interact.

A bigger leak is contributions. If you lower what you put in to afford the payment, you lose those contributions and any employer match on them, which the table does not count.

The main trap: leaving your job

A plan can require you to repay the whole balance when you leave or when the plan ends. If you cannot, it can reduce your account by the unpaid amount, a plan loan offset. Since 2018 you have until your federal tax return due date, including extensions, for the year of the offset to roll that amount into an IRA or another plan, using other money. Whatever you do not roll over is taxed as a distribution.

When each one wins

The 401(k) loan is often the better tool when:

• Your job is secure and you expect to stay until the loan is repaid.
• Your credit would get a high APR, well above the plan's rate.
• You can keep contributing at the same level while you repay.

The personal loan wins when:

• You might leave or lose your job within the repayment period.
• You qualify for an APR close to the plan's rate, so the saving is small.
• You are close to retirement, or the loan would take a large share of your balance.
• You have other cash. If savings could cover part of the cost, see personal loan vs. using savings.

How to decide in five steps

1. 1 Read your plan's loan rules: rate, fees, how many loans it allows and what happens when you leave.
2. 2 Price a personal loan with lenders that prequalify with a soft credit check, and note each APR and fee.
3. 3 Compare the payments and total interest over the same term. The rate change calculator shows what a few points of APR mean in dollars.
4. 4 Ask whether you can keep contributing while you repay. Lost contributions and match can outweigh the interest saving.
5. 5 Plan for the exit. If you left next year, could you repay or roll over the balance? If you own a home, also compare a HELOC.

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