As many people know, a 401k is a company-sponsored retirement account that an individual can contribute to get things started. In most cases, a company will add or match to that account as long as you work for them. Whether you have a standard 401k or an after-tax dollars 401k account, you should be able to borrow from it. These loans can be a great way to borrow your own money if you need emergency funds.
If you are thinking of a 401k loan, you may be curious about whether it impacts your credit; the good news is that it doesn’t! Below you will find more information on how these installment loans work and why they don’t have any impact on your credit score. You’ll also learn more about the different advantages and disadvantages of 401k loans and their alternatives.
Why Won’t A 401k Loan Affect Credit?
When you borrow money from a comparable consumer loan, such as a personal loan, a few different steps will impact your credit.
When you initially apply, lenders will look at your income (after your income is taxed rather than taxable income) and your credit score. This pull of your credit will affect your credit score. If you are approved for the loan and decide to take it out, the lender will report that new loan amount to the credit reporting agencies. Then how you make your loan payments will also be reported to the credit bureaus and be a part of your credit history. Making on-time payments will help your credit score while missing payments or defaulting on a loan will harm your credit score.
With a 401 k loan, you will be borrowing money from yourself. And so, since you are getting loan funds from your own account, you won’t have to go through the same process as a traditional loan. That means there is no lender that reports to the credit bureaus when you apply or make your loan repayments. If you default on the 401 k, it won’t be a part of your credit report and history, but you will have to pay income taxes on the outstanding loan balance.
More Details on a 401K Loan
As mentioned above, the basic definition for a 401k loan is that it helps you borrow from your 401k retirement savings account. If you are thinking about this option, the first thing you need to do is find out whether your plan lets you borrow from it. Sometimes, you may be unable to and have to look at other options to borrow funds. Additionally, to borrow from your 401k plan, you will need to have a balance.
Do You Pay Interest on a 401k Loan?
Yes, you will have to pay interest on your 401k loan as you pay it back. However, unlike a traditional loan that has a lender, with a 401k, you are borrowing from yourself, which means that you will be paying yourself in interest and principal. Just like a traditional loan, there will be a timeframe to make those monthly payments.
Is There a Limitation on How Much I Can Borrow With a 401K Loan?
Yes, there can be limitations on how much you can borrow from a 401k loan. Obviously, the amount in your 401k account will impact how much you can borrow. Most 401k retirement accounts limit you to 50% of your vested account balance, or $10,000, whichever is the greater amount. There is a limit of $50,000 you can borrow from your 401k, even if your balance is high enough to borrow more than that amount.
How Long Do I Have To Repay My 401K Loan?
If you do decide to borrow from a 401k loan, you can have up to 25 years to repay the loan if the loan is being used to buy a primary residence. Generally, most people repay their loan in about 5 years or so.
What Will Interest Look Like With a 401K Loan?
With a 401k loan, the interest rates will be pretty similar to other similar loans on the market. Looking at the average interest rates for a personal loan or another type of unsecured loan option will give you a pretty good idea of what to expect with interest rates on a loan.
What Can I Use a 401 K Loan For?
A 401k loan can be used for almost any purpose; here are some of the common reasons that people take out one of these loans:
- Buying a house.
- Paying bills and expenses.
- Early debt payoff, especially for high-interest debts such as credit card debt.
- Debt consolidation.
- Covering medical expenses.
- Down payment for making a large purchase, such as a car.
- Making home improvements and repairs.
- Vacation expenses.
What Happens if I Leave My Current Job With a 401 K Loan?
You’ll have a few options if you leave your current job while you have a 401k loan. You will have to repay your loan by the tax-return-filing due date for that tax year. This includes any extensions, Or you can decide to roll that loan over into another eligible retirement account.
Is It a Good Idea To Borrow From a 401K Loan?
Early withdrawal from your retirement fund and investment account, such as a 401k, can have pros and cons. Here are a few things to think about before deciding to take out a 401k loan:
- Borrowing from yourself means paying yourself back rather than another lender.
- You will get a better interest rate with a 401k than a comparable option if you have bad credit.
- If you cannot pay back your 401 k loan, you won’t have money left for your retirement, which can be a huge financial issue. Saving money for retirement is crucial!
- Any loan, including a 401k loan, can lead to having too much debt to pay each month.
- If you cannot pay back your 401k loan, you will end up paying taxes on the unpaid amount.
- It can slow down contributions to your retirement account.
Alternatives to a 401 K Loan
A 401k loan may not be an option for everyone or may not be accessible. The good news is that other options can work well as an alternative; here are some financial products to consider:
A Home Equity Loan or Home Equity Line of Credit
A home equity loan allows you to borrow funds from the value you have in your home. Because these loans are secured, you don’t need a great credit score. Depending on the equity in your home, you could get thousands of dollars with the right loan. A home equity line of credit is similar to a home equity loan in that you borrow from the equity in your home. However, unlike a loan, where you get the funds in a lump sum, you will get a credit line which you borrow from as you need.
A Personal Loan
A personal loan is one of the most versatile loan options available. They can be short-term or long-term loans, ranging in funding from a few hundred dollars to thousands. You can use a personal loan for almost any expense, including paying monthly bills, medical costs, car repair, down payment on a large purchase, etc. In most cases, there are bad credit loan options available as well. Most of the time, these loans will be repaid in steady monthly payments.
Credit Cards
Credit cards are some of the popular borrowing options out there. You’ll need good credit with these revolving credit options, especially if you want to borrow a considerable loan amount. As you repay your credit cards, you’ll be able to use the funds again, which can be pretty convenient. However, this convenience also sometimes can lead to a cycle of debt.
Consider a Taxable Withdrawal
A taxable withdrawal is an alternative you can consider to a 401 k loan. With this, you will be just taking out the funds from your 401k account but won’t have to repay it. In most cases, this withdrawal will be taxed, and there are a handful of things you should consider before going down this route. However, if you are facing financial hardship and need fast funds, this can be an excellent option.
The Bottom Line About How a 401k Loan Affects Your Credit
A 401 k loan will not affect your credit in any way. This is because you will be borrowing money from yourself rather than a lender. Since you are essentially the lender for your loan, there won’t be any communication between a credit bureau. The only consequences you will have if you don’t pay back your 401k loan is that you won’t have that money in your retirement account when it is time to retire, along with paying taxes on the unpaid loan amount. If you don’t want to borrow from your 401k, the good news is that there are several alternatives you can look into. Personal loans, home equity loans, credit card options, and taxable withdrawals are available. No matter what option you choose, definitely research the ins and outs of these loans!
References:
401(k) Loans: 7 Things To Know About Borrowing | Credit Karma
