Pros and cons borrowing against a 401(k): What to know

When you need to borrow money, an unlikely source of funds is your workplace retirement account. Most employers allow workers to borrow from their 401(k) without requiring a credit check or income verification. The application process is generally quick and easy, and the money is typically repaid through payroll deductions. While a 401(k) loan is simple to get, you need to understand the pros and cons of borrowing against 401k accounts before submitting your application.

What is a 401(k) loan?

A 401(k) loan is when you borrow against your workplace retirement account. These retirement accounts are tax-advantaged ways to save for the future through regular payroll contributions. Some employers contribute to the account through matching contributions, profit sharing, or other methods.

Since these accounts are geared for retirement, the maximum you can borrow is capped at $50,000 or 50% of your vested balance. Employers are not required to offer 401k loans, but most offer this feature. You can borrow against the total of your contributions and the vested amount that your employer has contributed on your behalf. If 50% of your vested account balance is less than $10,000, you may borrow up to $10,000. However, companies are not required to include this exception in their retirement plan.

Retirement plan loans do not require a credit check. Since your employer already knows how much you pay each pay period, you don't need to submit income verification documents either. In most cases, 401(k) loan applications are approved quickly if they meet the eligibility criteria.

Pros and cons of borrowing against a 401k

Using your retirement account for short-term financing can make sense in some situations. To better understand if this loan is right for you, you need to understand the pros and cons of borrowing against a 401k.

Pros

• No credit checks. You can borrow against a 401k account without needing to have a good credit score. In fact, 401k loans do not affect your credit at all.
• Quick approval process. If you're eligible to borrow from your retirement account, you can get approved quickly and have access to the money within days.
• Avoids taxes and penalties. When you borrow against your 401k instead of taking a withdrawal, you won't have to pay income taxes on the money or early withdrawal penalties if you're under age 59 1/2.
• You pay yourself the interest. Personal loans pay interest to the bank. With a 401k loan, you pay yourself interest on the loan.

Cons

• Maximum loan limits. The most you can borrow against a 401k is $50,000 or 50% of your vested balance, whichever is less. If you need more money, you'll need to find other sources to borrow from.
• Risk of job loss. If you leave your job or are fired, you must repay the loan in full immediately or potentially owe income taxes and an early withdrawal penalty on the remaining balance.
• Does not build credit. Loan payments for 401k loans are not reported to the credit bureaus, so these loans will not help you build a positive credit history.
• Short repayment period. The maximum loan term when borrowing from a 401k is five years. A short repayment period can cause monthly payments to be unaffordable to some borrowers.
• Missed opportunity for compound growth. Taking from your nest egg, can significantly decrease what you have saved for retirement.

When borrowing from a 401K can make sense

Borrowing from a 401k makes sense when you've exhausted all other affordable lending options. Most experts are against 401k loans because your money isn't invested during loan repayment, and you may owe income taxes and penalties if you leave your job before the loan is repaid in full.

That being said, if you have bad credit, getting a 401k loan may be one of the few options you have to get the money you need quickly. Approval for 401k loans is generally quick, and you can borrow up to $50,000 without a credit inquiry or having to qualify based on your income. With a five-year repayment period and reasonable interest rate, monthly payments are usually affordable.

Alternative loan options that don't require perfect credit

Borrowing from your 401k isn't the best option for every situation. Here are some alternative loan options to consider if you have trouble getting approved for a loan:

• 401(k) hardship withdrawal. If your 401(k) plan allows it, you may be able to withdraw money for certain immediate and significant financial needs. Hardship withdrawals don't have to be repaid, but they may be subject to income taxes and an additional tax depending on your circumstances. Because the money isn't repaid to your account, a hardship withdrawal can also create a significant retirement savings shortfall if you don't make up for it with increased contributions in the future.
• Credit cards.  Some credit cards offer promotional interest rates, including 0% intro APR periods, which can make them a lower-cost option for short-term borrowing if you qualify. However, promotional periods are temporary, and any remaining balance may be subject to a much higher interest rate once the offer ends. If you have an existing credit card, you can use it without a credit inquiry, but you are limited to your current credit limit.
• Home equity investment (HEI). You can get approved for up to $600,000 with an HEI based on your home equity. You don't have to verify your income or have perfect credit, and there are no monthly payments. The HEI gives you a lump sum of money upfront in exchange for a share of your home's future appreciation.
• Home equity line of credit (HELOC). A HELOC is a flexible equity line of credit with interest-only minimum payments. Most lenders require good credit, but you may get approved if you have high income or a low loan-to-value ratio.

A 401(k) loan can provide financial relief, with advantages like no credit check and interest payments that go back into your own account. However, borrowing from your retirement savings can mean missing out on potential compound growth, which may affect your long-term goals. Before moving forward, consider speaking with a financial advisor and exploring all your options to find the approach that best fits your needs.