What you need to know about 401(k) loans

If your plan allows it, you may be able to borrow up to 50% of your vested balance—that's 50% of the portion of your account that’s yours, without conditions. You’ll repay this amount, plus interest, back into your 401(k) account over time through payroll deduction. General loans must be repaid in 5 years or less, and home loans in 10 years or less.

Typically, the interest rate on 401(k) loans is what’s known as the prime rate—currently, 4.75%; depending on plan rules, though, it may be higher. The higher the interest rate, the higher your monthly payment. For example, for a $5,000 general loan with a 5-year (60-month) repayment term, your payment increases as the interest rate grows.

This is a hypothetical mathematical example, for illustrative purposes only.

Sometimes plans also charge loan processing or annual maintenance fees, which are taken out of your 401(k) account, not out of the loan amount. Unlike loan payments, loan processing fees aren’t repayable—they never go back into your retirement account. 

For some, the only alternative to a 401(k) loan is running up their credit card balance, and because credit card interest rates can reach the high teens and compound daily—meaning the interest you owe builds quickly—401(k) loans are usually a cheaper option. 

Your monthly and total payments on a credit card with 19% interest will be 33% higher than your payments on a five-year 401(k) loan with 5.75% interest.¹

Other potential advantages to a 401(k) loan include:

• No preapproval requirement—A 401(k) loan can usually be processed online or over the phone, except in the case of a residential loan with a 10-year repayment, which may require paperwork.
• Interest payments go into your 401(k)—You pay interest to yourself. 
• Repayment is automatic—Principal and interest are repaid through payroll. 

The biggest drawback to a 401(k) loan is that the money you borrow doesn’t earn an investment return, and this can cost you. 

If you take a five-year loan at an interest rate of 5.75% (prime + 1%), your loan balance will be more than 30% less than if you’d left that amount invested and growing at 5%.¹ There are other drawbacks:

• If you don’t repay your loan, it goes into default. A defaulted loan becomes a withdrawal and may be subject to taxes and penalties. It also permanently drains your retirement plan.
• Loan fees are paid to the service provider. Fees vary, but they're usually in the range of $50 to $75 and can be ongoing.
• You normally have to pay back your loan immediately if you leave your job. If you’re considering a job change, you’ll need to make plans to repay your loan so that you don’t default on it.
• 401(k) loan interest is double taxed. You pay loan interest into your 401(k) with after-tax dollars, and you’re taxed on those same dollars again in retirement.

Loans taken during sharp stock market pullbacks can be especially harmful to the future growth of your retirement plan because stocks tend to recover. Depending on how quickly stocks bounce back, your loan repayments may buy shares at higher prices than the prices at which you sold when you borrowed. In this case, you’ll end up with fewer shares than you started with and lower account growth than if you hadn't taken the loan. Also, because loan funds aren’t invested, you miss out on potential market appreciation—which can be substantial after a large drop. 

Loans can be habit forming. Statistically, people who’ve borrowed before are more likely to borrow in the future than people who haven’t borrowed at all. 

If you’re thinking of borrowing from your 401(k), plan ahead by asking your 401(k) service provider about the borrowing process, such as:

• Are loans allowed? Ask about the types, terms, and costs.
• How much can I borrow? This varies with your plan balance.
• What are the steps? Processes differ, and there may be paperwork if you want a home loan. 

Keep in mind that loan checks are usually mailed, so they may take time to reach you. 

401(k) loans have unavoidable drawbacks, but you can lessen their impact by doing these four things: 

1. Don’t request more than you need—The more you borrow, the more you lose out on earnings.
2. Repay it in full as soon as you can—The faster you pay it back in full, the smaller your lost earnings will be.
3. Keep contributing—Don’t lose out on your company match!
4. If you leave your company, try to pay your 401(k) loan back. 

While 401(k) loans can be a convenient alternative to a high-interest credit card, it’s important to remember that these loans can be harmful to your retirement plan since the funds you withdraw aren’t invested until they’re repaid, loan interest is taxed twice, and a loan not repaid can trigger taxes and penalties.

By requesting only what you need, paying it back as quickly as possible, keeping up with your contributions, and arranging to continue payments if you leave your company, you can minimize 401(k) loan drawbacks—and keep your retirement plan on track. 

1 These are hypothetical mathematical illustrations only. Figures are based on assumptions as set out, and individual circumstances may vary. Returns are not representative of any particular investment.