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Personal Loan vs 401k Loan? How to Decide

| Money Rates Columnist.
min read

alarmed-piggy-bankSo your bank account is on life support, and you're considering applying for a personal loan or borrowing against your 401k plan. What are the plus and minuses or taking a personal loan instead of 401k loan? Wonder no longer. We will walk you through them.

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Personal Loan vs 401k Loan

When you need more than a credit card can provide (at a reasonable cost) and home equity financing isn't doable, personal loans and 401k loans may hit the mark perfectly. Both are easy to apply for and both provide the money quickly.

The main difference between the two is that personal loans are unsecured. That means there is no property securing the loan if you fail to repay it. Nothing for a lender to repossess. While a 401k is secured by the balance in your retirement account. And the lender, in the case of the 401k account, is you. You are borrowing from yourself.

Personal Loan Pros and Nos

Pros:

  • Personal loans are unsecured by collateral. If you find yourself unable to repay your loan, the lender cannot repossess your home, car or retirement account balance.
  • Interest rates are fixed. Personal loan interest rates are almost always fixed. That makes budgeting easier.
  • Installment loans have finite terms. Because they are installment loans, personal loans have definite ends. Your debt won't go on forever.
  • You can borrow $1,000 to $100,000. Setup costs are low and usually based on the loan amount. So a smaller loan doesn't usually have huge costs.

Nos:

  • You may get a "no" from a lender. Personal loan lenders are in business to make money. If your debts are too high or your FICO score is too low, a personal loan might not be available or economical.
  • Payments may be high. Because personal loans have definite terms, your payment is likely to be higher than the minimum for a credit card and possibly more than a five-year 401k loan. That's good for debt repayment but may be hard on your cash flow.

401k Loan Pros and Nos

Pros:

  • Approval likely.

    As long as your employer's plan allows borrowing, and your balance is healthy, getting a yes shouldn't take long.

  • Save money on the loan.

    Since lenders aren't judging your credit history and financial situation, generally, you'll see low interest rates on these types of loans.

  • The interest goes to you.

    You do have to pay interest on a 401k loan (sorry), but the interest is going back into your retirement plan balance. So on the plus side, you're paying interest to yourself.

  • Missed payments can be made up without penalty.

    And late or missed payments are not reported to credit bureaus.

Nos:

  • You could slow down your retirement plan.

    You can't contribute to your plan as long as you owe money against it. That means your tax bill will likely be higher. In addition, you repay your loan with after-tax dollars, which reduces money available for retirement savings.

  • Fees may make it not worth it.

    401k plans often have fees for administering loans. If you take out a small loan, the fee you pay on it may negate some of the value of taking out the loan. And if it's a small loan with a big fee, you may be better off borrowing money in another way.

  • Risk of a tax penalty.

    If you quit or lose your job, you'll need to repay the 401k loan by the end of the year tax year. And if you don't? Under IRS guidelines, your loan may convert to an unqualified distribution from the plan, and so you'll owe ordinary taxes on the balance - plus a 10% penalty.

  • Loan limits.

    You may not be able to borrow as much as you were thinking. Usually you can't take more than half of the balance on the loan up to $50,000. That said, if you have less than $20,000 in the plan, you can borrow up to $10,000 or the total amount of the balance (whatever is less). You also may have other rules that prevent you from borrowing a certain amount, depending on the plan.

Personal Loan or 401k Loan: Which Is Right for You?

Should you get a personal loan or a 401k? Unfortunately, there's no universal answer. It really depends on your situation.

The case for a personal loan is strong if you qualify for the lowest interest rates and can afford the monthly payment. You'd also lean toward a personal loan if your job situation isn't rock solid - if you're looking elsewhere or your position is shaky for any reason, a personal loan is much less risky than a 401k loan. It doesn't help to save 15% on interest if you get hit with 40% in penalties for leaving your employer. A personal loan also makes sense if you don't need to borrow more than a few thousand dollars. That's because the setup and admin costs of a 401k loan could be disproportionately high when you borrow a small amount.

On the other hand, you have a pretty good argument for getting a 401k loan if you feel very secure in your job. That's even more true if your credit isn't good enough to get an affordable personal loan interest rate. Most 401k plans don't charge you more interest if your credit is bad, and in any case, you pay that interest right back to yourself. Another advantage of 401k loans is that you can make up missed payments without penalty and without harming your credit.

If you take a loan against your 401k, and then want or need to leave your job, you may be able to prevent some or all of the tax penalties by paying off the 401k loan with a personal loan. Read on to see how.

Leaving Your Job With a 401k Loan? Avoid Penalties With a Personal Loan

According to the Employee Benefits Research Institute, about one-fifth of eligible employees with 401k plans borrow against them. That said, it can be a risky move. You could end up owing as much as 50% of the loan amount in taxes and penalties.

There are three scenarios in which this could happen:

  • You resign and go to a different job with another employer.
  • The company you work for goes out of business.
  • You're laid off or fired.

If there is a good possibility that you'll leave your job before you can repay the 401k loan, consider protecting yourself by repaying it with a personal loan. If you're concerned about your job security, get your personal loan while you can still be approved - before you lose your job.

401k Loan Repayment Period

If you do end up leaving your employer, you can dodge those penalties on your 401k loan if you repay the loan before the due date for the next year's tax returns. You can even get an extension if you needed to. So if you quit your job in January 2019, you should have until October 15, 2021, with an extension, to pay off your 401k loan.

Penalties for Failing to Repay Your 401k

If you miss the repayment deadline, your employer will file a Form 1099-R with the IRS. If that happens, your remaining loan balance is considered income - and it'll be taxed at your ordinary income tax rate. On top of that, you'll pay a penalty of 10% of the balance if you're younger than age 55 and retired (age 50 in some cases for police, firefighters and EMTs) or younger than 59 1/2 and still working.

The math can get ugly. Assume that you owe $10,000 against your 401k and leave your job and your federal tax bracket is 32%. And your state rate is 5%. You're still young, working and owe a 10% penalty. Altogether, that's 47%. Instead of owing the $10,000 you borrowed, you need to pay back $14,700!

The math gets even more hideous. The IRS charges an underpayment penalty and interest on that $14,700 until you clear the debt. Currently, that's 0.5 percent each month plus 5.72% interest as of this writing. So if it takes you five years to clear your IRS debt, your payment would be about $325 per month. When the smoke clears, it will have cost you $9,495 to borrow $10,000.

Avoid Penalties: Pay 401k Loan With a Personal Loan

If you do have trouble paying back the 401k loan, you probably will want to try repaying it with a 401k loan. For starters, your loan won't be designated income by the IRS, and you can escape income tax and the penalty. These things can always change, but at the moment, the average personal loan is a little under 11%.

Assuming that you owe $10,000 on a 401k loan, and want to head off the IRS, your payments at 11% over five years would be $217 and it would cost you $3,045 to borrow $10,000.

Your Decision

To summarize the personal loan vs 401k decision:

  • The 401k loan is cheaper as long as you repay the loan on time, don't leave your place of employment, repay the loan as soon as possible and increase contributions to boost retirement savings once you are 401k debt-free.
  • The personal loan can be cheaper if you have excellent credit and don't need to borrow a lot of money.
  • The 401k loan is a cheaper choice for people with bad credit as long as they pay the loan back without penalties.
  • You may be able to get yourself out of IRS trouble by paying the 401k loan off with a personal loan. But you probably can't qualify once you lose your job. Line up the personal loan before parting ways with your employer.

To make a smart decision, get quotes for personal loans and see if you can afford the payments. Inquire about your 401k plan and verify your company's rules. In general, 401k loans are cheaper but riskier. Personal loans cost more but are safer.

Compare personal loan interest rates and terms here

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