How Does a 401(k) Loan Work for Paying off Debt?
- A 401(k) loan can sometimes be a good way to pay off high-interest debt.
- The interest you pay on a 401(k) loan goes back into your own savings, and you don't have to undergo a credit check.
- There are downsides to 401(k) loans, including double taxation and loss of investment opportunity.
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When you're struggling with debt, one solution for paying it off could be to borrow against your 401(k) plan with a 401(k) loan. In most ways, a 401(k) loan works like any other loan: You borrow a lump sum and pay it back over time. Only here, you're borrowing the money from your own retirement savings.
There can be benefits to using a 401(k) loan to pay off debt, but there are also risks involved. Let's explore the pros and cons so you can make an informed decision.
What Is a 401(k) Loan and How Does it Work?
A 401(k) loan is a loan you take out against your retirement plan balance. Not every retirement plan allows borrowing against a 401(k). If yours does, you may be able to borrow up to half of your vested account balance, or up to $50,000—whichever amount is less.
When you take out a 401(k) loan, you repay your balance (plus interest) on a preset schedule. Often, 401(k) loan payments are deducted from your paychecks automatically. You generally have up to five years to repay a 401(k) loan, but in some cases, you may be looking at a shorter repayment period.
If your 401(k) plan doesn't let you take out loans, a withdrawal is usually not a good source of funds—if you take a 401(k) withdrawal before age 59 and a half, you generally face a 10% early withdrawal penalty. A $10,000 early withdrawal, for example, could immediately cost you $1,000.
Benefits of Using a 401(k) Loan to Pay Off Debt
There are a number of benefits to using a 401(k) loan to pay off high-interest debt.
You may qualify for a lower interest rate
Interest rates on 401(k) loans are often considerably lower than interest rates on other loans. That could make your payments more affordable.
You're paying yourself back
When you take out a personal or home equity loan, the interest you pay goes into your lender's pocket. When you take out a 401(k) loan, the interest you pay goes back into your own savings.
You aren't be subject to a credit check
Poor credit could get in the way of qualifying for a debt consolidation loan. With a 401(k) loan, there's no credit check, since you're borrowing against your own balance. Poor credit shouldn't stop you from qualifying.
No credit score impact
Ideally, you'll repay your 401(k) loan on time. But if you fall behind, late payments don't hurt your credit score the way late payments for most loans do. In fact, your 401(k) loan shouldn't show up on your credit report at all.
Drawbacks of Using a 401(k) Loan to Pay Off Debt
While there are benefits of using a 401(k) loan to pay off debt, there are some drawbacks you should be aware of, too.
Lost investment growth
Money you borrow from your 401(k) is money you're not investing while you're repaying your loan. You could lose out on market gains, leaving you with a smaller 401(k) balance than you would have had if you hadn't taken the loan.
You may have to pause contributions
Some 401(k) plans don't allow borrowers to make contributions while a loan is outstanding. Not only does this mean losing out on saving for retirement, it could also mean losing the tax break on traditional 401(k) plan contributions.
Double taxation
While traditional 401(k) plans are funded pre-tax, you make 401(k) loan repayments with your regular, taxed income. Then, when you take withdrawals from your 401(k) in retirement, those distributions are taxable too, effectively creating a double-tax situation. Consult with a tax professional to understand the potential implications.
Risk of default and early withdrawal penalty
If you don't repay your 401(k) loan on time, it’s treated as a distribution. If you're not yet 59 and a half years old, you generally incur a 10% early withdrawal penalty on the sum you didn't repay.
You don't get much time to repay if you lose your job
You might think you'll have several years to repay your 401(k) loan, no matter what. But if you leave your job, whether by choice or due to a layoff, you typically have to repay your remaining loan balance in a very short time. If you can’t, it’s treated as a withdrawal, which could result in penalties.
Alternatives to Using a 401(k) Loan to Pay Off Debt
If your 401(k) plan doesn't allow loans, or you're not comfortable borrowing against your retirement savings, there are alternatives:
You can use a personal loan, home equity loan, or HELOC for debt consolidation.
You can do a balance transfer to move credit card balances onto a single card.
You can seek help from a debt relief company, especially if your debt has become overwhelming and you don't see a way out.
You can consult with a credit counseling agency to see if a debt management plan is right for you.
The Bottom Line on Using a 401(k) Loan to Pay Off Debt
A 401(k) loan could be an easy and inexpensive way to pay off high-interest debt compared to other loan types. But if you take out a 401(k) loan to pay off debt, make sure you understand your plan's rules and terms, as well as the risks involved.
Author Information
Written by
Maurie Backman
Maurie Backman is a personal finance writer with over 10 years of experience. Her coverage areas include retirement, investing, real estate, and credit and debt management.
Reviewed by
Kimberly Rotter
Kimberly Rotter is a financial counselor and consumer credit expert who helps people with average or low incomes discover how to create wealth and opportunities. She’s a veteran writer and editor who has spent more than 30 years creating thousands of hours of educational content in every possible format.
Do you have to pay interest on a 401(k) loan?
You do. However, interest rates on 401(k) loans are often lower than those of many other types of consumer loans. Better yet, you'll be paying that interest back into your own retirement account.
Is a 401(k) loan cheaper than a personal loan?
Yes, just in terms of interest rates, 401(k) loans are generally cheaper. It’s good to understand the other potential costs that come into play for 401(k) loans. When you borrow against your 401(k), the money comes out of your 401(k) balance. That money then can't be invested until you pay it back. This will likely result in missed investment growth on your money. In the event you don’t meet the repayment terms of your loan, you could get hit with a tax bill or a penalty.
What happens if I can't repay my 401(k) loan?
An unpaid 401(k) loan won’t go to collections or show up on your credit report.
In most cases, the amount you don’t repay will be treated as a taxable distribution from the plan. That means it could be subject to ordinary income taxes plus a 10% early withdrawal penalty if you’re under 59 1/2. It also means a permanent decrease in your retirement savings and a loss of investment growth on that money.