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What is a 401K Loan?

What is a 401k Loan?

Banking

What is a 401K Loan?

If you work for an employer, you might be able to save for retirement with a 401k plan. When you need to borrow money and cannot get the financing you need from your local bank or credit union, you can also obtain the money you need with a 401k loan. Before you ask your 401k plan administrator there are a few things you need to know.

Not Every 401k Plan Offers Loans

While many employers offer 401k retirement plans, not every plan offers 401k loans. If you work for a small business with only a handful of employees, it is very likely that you will not have a 401k loan option. It’s simply too expensive of a tool that your employer cannot afford. After all, the traditional purpose of a 401k plan is to save for retirement.

You will need to check with your employer’s human resources department or your 401k plan administrator to see if they offer loans.

You Can Only Borrow For Specific Reasons

There are also limitations on why you can borrow. Each 401k plan can have different reasons, but, here are a few eligible reasons you can qualify for a 401k loan:

  • Pay for unreimbursed medical expenses
  • Buying a primary residence
  • Home repairs
  • Prevent foreclosure or eviction
  • College education expenses for you, your spouse, or children
  • Death-related expenses

Some plans will let you borrow for any reason. Looking at your 401k plan summary can provide additional information on if you qualify for a 401k loan.

You will need to show documentation to support the reason for your loan request. As many 401k loans are viewed as hardship loans, your 401k plan administrator might expect you to first apply for financing from a bank.

Application Fees for 401K Loans

There are application fees with 401k loans. You can expect to pay approximately $40 per request.

If you have the loan for more than one year, you can also expect to pay an annual maintenance fee of approximately $25.

You can also repay a 401k loan early with no prepayment penalties.

Borrowing Limits

You can only borrow up to 50% of your 401k account balance or $50,000, whichever is less. And, the balance often needs to be repaid within five years. Home purchase loans have up to 10 or 15 years to be repaid.

While a 401k loan can help you purchase a new home, you won’t be able to avoid getting a mortgage for the rest of the home purchase due to the limited borrowing limits.

If you quit or lose your job before you repay your loan, you will also only have 60 days to repay the remaining loan balance. After those 60 days are up, any remaining loan balance will be considered an early withdrawal and will be subject to a 10% penalty and any applicable taxes and fees.

Some plans might allow you to take out two different 401k loans at once, while others will only allow one at a time.

Interest Rates

Interest rates for 401k plans are often based on the Prime Rate and add an additional one or two percentage points.

If the Prime Rate is 4.25%, you can expect to pay between 5.25% and 6.25% on your 401k loan.

Advantages of 401k Loans

Here are a few reasons you might choose to apply for a 401k loan:

  • Usually no credit check
  • Simple and efficient application process with minimal paperwork
  • Interest rate can be lower than a traditional bank loan
  • Can borrow money up to five years for general loans and up to 15 for home loans

Disadvantages of 401k Loans

There are also a few downsides that don’t make 401k loans the best option:

  • Retirement accounts will not earn as much interest
  • Have to pay application fees and annual maintenance fees
  • Can only borrow up to $50,000 or 50% of your portfolio value
  • Must repay balance in full within 60 days if you quit or lose job
  • Other loans have lower interest rates like auto loans and home mortgages.

Summary

A 401k loan can be a good option if you need quick access to credit before a bank can complete the traditional loan application. A 401k can also be a good alternative to high-interest credit card balances or payday loans. Many financial advisors do not recommend 401k loans because you can greatly reduce the growth potential of your retirement savings. If you only plan to borrow for a short time period, a 401k loan can be a better option than choosing a loan with a significantly higher interest rate.

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