Withdrawals Are An Alternative To 401 Loans
A 401 loan is generally preferable to a 401 withdrawal if you must use the funds in your retirement accounts to meet your immediate needs. A loan is a better alternative because:
- You avoid the 10% early withdrawal penalty that applies if you take money out of your 401 before age 59 1/2.
- You’ll repay the money to your 401 so it will not permanently lose out on all of the investment gains it could have earned between the time of the withdrawal and the time you retire.
Before considering a 401 withdrawal and incurring both the penalties and losing gains for the remainder of the time until retirement, you should seriously think about taking out a loan instead if your plan allows it.
Repayment Terms On 401 Loans
- You must pay back your loan within five years. You can do so via automatic payroll deductions, the same way you fund your 401 in the first place. There is no penalty for paying off the loan sooner than that.
- You must pay interest on the loan, at a rate specified by your 401 fund administrator. Typically the rate is calculated by adding one or two percentage points to the current prime interest rate.
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Does A 401 Loan Hurt You
A 2020 report from the Transamerica Center for Retirement Studies found that millennials are already taking out loans against their retirement savings at almost double the rate of older generations. Even so, a 2021 study from the same organization shows that other generations arent faring much better. So if youve been trying to beat the odds and put aside adequate savings for retirement, taking out a 401 loan can be a triple whammy.
First, some plans dont allow participants to make plan contributions while they have an outstanding loan. If it takes five years for you to repay your loan, that could mean five years without adding to your 401 account. During that time, you may be failing to grow your nest egg and youll miss out on the tax benefits of contributing to a 401.
Next, if your employer offers matching contributions, youll miss out on those during any years you arent contributing to the plan. Loan repayments arent considered contributions, so if the employer contribution is dependent upon your participation in the plan, you may be out of luck if you cant make contributions while you repay the loan.
And finally, your account will miss out on investment returns on the money youve borrowed. Although you do earn interest on the loan, in a low-interest-rate environment you could potentially earn a much better rate of return if the money was invested in your 401.
What are the tax benefits of 401s?
How Do You Pay Back A 401k
The loan must be repaid within 5 years through payroll deduction unless the money is used to purchase a primary residence where the borrower will live full time. The employee must make payments at least quarterly. If the loan is not repaid on time, it is recognized as taxable income and the amount is hit with a 10% early withdrawal fee.
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Maximum Borrow Amount From A 401k
For 401k plans that permit the employee to take out a loan, it is usually possible to borrow up to 50% of the amount vested in the plan to a maximum of $50,000, whichever is less. Some plans offer an exception to the 50% limit for those with a balance less than $10,000. In this case, the employee can borrow up to $10,000. The maximum amount is set by the Internal Revenue Service. However, different plans have different borrowing limits.
The Benefits Of A 401 Loan
While borrowing from your retirement fund isnt ideal, it does have a couple of distinct advantages over taking out a short term loan from a bank or credit union. In the first place, the application process is relatively simple, and in many cases can even be completed online. You only have to log into your account, fill out a form, and click a few buttons. If you are applying for a personal loan, you wont even be asked what the money is for. Once your loan is approved, you can even have the funds deposited directly into your bank account. Compared to traditional lenders, applying for a 401 loan is remarkably quick and easy.
The second most important benefit of a 401 loan concerns the interest. With a traditional loan the interest you pay goes directly to the lending institution. Its the price you pay for the luxury of borrowing money from a bank or credit union. However, with a 401 loan the interest you pay goes back into your retirement fund. Essentially, you are borrowing money from yourself and you reap the benefits of the paid interest. Keep in mind that while the proceeds of your loan are tax exempt, the interest on that loan is not. Still, the balance almost always works in your favor.
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Do 401k Loans Affect Credit
When borrowing from your 401, you may be wondering how the 401 loan affects your credit and whether it appears on a credit report. Here is everything you need to know.
If you need to raise cash for a short-term liquidity need, a 401 is one of the first places you should consider. Taking a 401 loan can help you avoid the high-interest payday days or credit card loans, and instead borrow against your savings. Although some financial analysts describe 401 loans as an act of robbery against your retirement savings, a 401 loan provides greater convenience, speed, and repayment flexibility.
A 401 loan does not affect your credit score or debt-to-income ratio, since you are borrowing against your retirement money. A 401 loan is not technically a debt, and it is not considered when calculating your debt-to-income ratio. If you donât pay the outstanding loan balance, you wonât owe any lender other than yourself. A 401 plan is not set up to offer lending services, and hence, the plan administrator cannot report the 401 loan activities to credit bureaus.
Other Alternatives To A 401 Loan
Borrowing from yourself may be a simple option, but its probably not your only option. Here are a few other places to find money.
Use your savings. Your emergency cash or other savings can be crucial right now and why you have emergency savings in the first place. Always try to find the best rate on an online savings account so that youre earning the highest amount on your funds.
Take out a personal loan. Personal loan terms could be easier for you to repay without having to jeopardize your retirement funds. Depending on your lender, you can get your money within a day or so. 401 loans might not be as immediate.
Try a HELOC. A home equity line of credit, or HELOC, is a good option if you own your home and have enough equity to borrow against. You can take out what you need, when you need it, up to the limit youre approved for. As revolving credit, its similar to a credit card and the cash is there when you need it.
Get a home equity loan. This type of loan can usually get you a lower interest rate, but keep in mind that your home is used as collateral. This is an installment loan, not revolving credit like a HELOC, so its good if you know exactly how much you need and what it will be used for. While easier to get, make sure you can pay this loan back or risk going into default on your home.
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Why Do People Get 401 Loans
As long as a plan allows it, participants generally can borrow from their 401 for any reason that they deem necessary. Some plans may only allow loans for specific reasons, so be sure to check your plans rules before trying to borrow.
Since youre borrowing your own money, and no credit check is involved, it may be easier to get approved for a 401 loan as long as you meet the plans requirements for borrowing. In some cases, a requirement may be getting approval from your spouse , because your spouse may be entitled to half of your retirement assets if you divorce.
Here are some potential uses for a 401 loan.
- Paying household bills and expenses
- Funding a down payment on a house
- Paying off high-interest debt
- Paying back taxes, or money owed to the IRS
- Funding necessary home repairs
- Paying education expenses
But that doesnt mean 401 loans are always a good idea. In fact, there are some major risks that come with borrowing from your retirement savings. Here are two.
What Is A 401 And How Does It Work
Before diving into whether you should use your 401 to buy a house, its important to first have a firm grasp on how, exactly, a 401 retirement account works.
Your 401 account is an earmarked savings account created specifically to help you prepare for retirement. As defined by the Internal Revenue Code of the IRS, 401 holders can claim a tax deduction and will see their contributions to the account accrue tax-free interest over time. The trade-off is that access to the account is strictly limited.
Withdrawals from a 401 should not be made before the account holder turns 59½, or before they turn 55 and have left or lost their job. Early withdrawals incur a 10% early withdrawal penalty on the amount of money being taken out of the account. This amount also immediately becomes subject to income tax, since its no longer in the protected retirement savings account.
While these regulations may seem harsh, they are in place to incentivize account holders to set aside enough money to support a comfortable retirement. That being said, its not illegal to withdraw money from your 401 early, and those funds can certainly be put toward a down payment on a house.
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Can You Pay Off A 401 Loan Early
Yes, loans from a 401 plan can be repaid early with no prepayment penalty. Many plans offer the option of repaying loans through regular payroll deductions, which can be increased to pay off the loan sooner than the five-year requirement. Remember that those payments are made with after-tax dollars unlike contributions, which are made before taxes.
Will A 401 Loan Appear On A Credit Report
When you apply for a 401 loan, the application process does not entail a, and your credit score will not be considered to determine if you qualify for a loan. Since you already own the retirement savings, the lender does not pull your credit report to check your credit history.
With a traditional loan such as a personal loan, you must undergo a credit check to determine your creditworthiness. Any new loan is recorded in your credit report, which also affects your credit score. However, if you get approved for a 401 loan, the new loan is not recorded on your credit report. Also, if you default on the 401 loan, the plan administrator will not report the default to credit bureaus, hence it will not appear on your credit report.
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Should I Use My 401 To Buy A House
There are good reasons for not using your 401 to buy a house. Even if youre comfortable with the 10% early withdrawal penalty, you will still be incurring long-term consequences by reducing your savings. That, in turn, will damage your future growth potential.
Taking out $10,000 from a $20,000 401 account, for instance, leaves you with only $10,000 that will continue accruing interest. With a 7% annualized rate of return, that $10,000 could become $54,000 over 25 years compared to $108,000 had you not withdrawn $10,000.
Withdrawing from your 401 account is essentially taking out a loan against yourself. If you want to pay it back, you also need to pay interest, and the time spent paying it back is time that could have been spent on growth.
What Impacts Your Credit Score
If you think a 401k loan is your only option, it’s worth taking steps to improve your credit score. Even if you move forward with the 401k loan, this financial improvement strategy will set you up for success in the future.
Some of the things that negatively impact your credit score include:
- Late or missed payments – make minimum payments even if you can’t pay down the debt, and ensure they’re paid on time.
- Debt ratio – how much you’re approved to borrow versus how much you actually use. Paying down existing debt will help.
- Collections or bankruptcy – these negative items will stay on your credit report for years and negatively impact your score.
- Hard inquiries – if a lender does a credit check for approval, it will slightly impact your score for a couple of years.
Identify which issues you struggle with and consider talking to a financial advisor for guidance.
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How Are 401 Loans Paid Back
401 loans are paid back in regular installments. Some plans require monthly payments, while others allow quarterly .
Certain plans require loan repayments to be taken out of paychecks, similar to standard 401 contributions. Other plans allow direct payments from your bank account.
All repayments including interest go back into your 401. Depending on your plans settings, they may be automatically invested, or you may need to manually purchase new investments.
Check plan details to be sure of your repayment plan.
Loans You Behind Financially While Pmi Does Not
In the example in a previous section, we showed how removing just $10,000 from a retirement account could result in a $50,000 lower balance at retirement.
Now imagine you remove $20,000 or even $30,000 to reach the 20% down payment mark to avoid PMI. The future losses are going to be way more impactful than the $200 per month outlay now. Dont sacrifice your retirement savings because youre averse to PMI. Look at the long-term, broader view.
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Loan Applications Impact Your Credit
Did you know that just applying for a loan can lower your credit score, even if it’s only by a few points? Thats because about 10% of your credit score comes from the number of credit applications you make.
Each time you apply for credit, an inquiry is placed on your credit report showing that a business has reviewed your credit history. Several inquiries, especially in a short period of time, may indicate that you are in desperate need of a loan or that youre taking on more loan debt than you can handleneither of which is good for your credit score.
If youre shopping around for a mortgage loan or auto loan, you have a grace period during which multiple loan inquiries won’t each have an effect on your credit score. Even after youve finished your rate shopping, the loan inquiries are treated as a single application rather than several. That window of time is between 14 and 45 days, depending on which credit score the lender checking your score is using. Therefore, you should aim to keep your loan shopping within a small frame of time to lessen the impact on your credit score.
They Can Help Raise Your Score But They Have To Be Repaid On Time
A personal loan can affect your in a number of waysboth good and bad. Taking out a personal loan is not bad for your credit score in and of itself. However, it may affect your overall score for the short term and make it more difficult for you to obtain additional credit before that new loan is paid back.
On the other hand, paying off a personal loan in a timely manner should boost your overall score. If you decide to take out one, be sure to research and compare all of your options thoroughly in order to qualify for the best possible loan.
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If You Default On Your 401 Loan You’ll Owe A Penalty
If you do not pay your 401 loan back as required, the defaulted loan is considered a withdrawal or distribution and thus is subject to a 10% penalty applicable to early withdrawals made before age 59 1/2. That’s potentially a huge cost, especially when you also consider the loss of the potential gains your money would have made had you left it invested.
Should You Tap Your 401 To Buy A House
Borrowing from your 401 isnt advisable, but some experts say it can be done in a pinch.
I wouldnt recommend it, but I will say that a loan from your 401 has a flexible repayment schedule, says Zhouhere. You can pay within the five years, or you can pay faster than that without penalty. You can also pay what you borrowed through payroll deductions, but using the after-tax dollars.
Others urge homebuyers to never remove money from their 401 to buy a house.
Ive been representing lenders and borrowers for 15 years, and Id never advise this, says Matthew Carter, an attorney at Las Vegas Inc and Go.
Buyers might think they are just borrowing the money from themselves, but they are really borrowing it from the future. Theyre losing the interest and value they can build on that money to purchase a home that will likely put them into further debt, adds Carter.
Homeownership comes with a lot of unexpected costs, and borrowing from your future to suffer those costs is reckless, he says.
Still, in the current competitive real estate market, tapping your 401 might be a worthwhile move, as long as you run the numbers and know that you can afford the fees.
Rising home values alone should make people seriously consider borrowing from their 401, says Chris Barnett at eXp Realty in Birmingham, AL.
Tapping your 401 fund is ideal if you need quick cash for short-term liquidity, Zhouhere says.
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