3 Reasons a Personal Loan Is Better Than a 401(k) Loan

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Need a loan? Read on to see why a personal loan may be a more optimal choice than a 401(k) loan. 

It’s not so unusual to run into a situation where you need access to money. Maybe your car needs a lot of work and it’s more cost-effective to make repairs than buy a new one. Or maybe you have a home renovation project you really can’t put off if you want to be able to live comfortably.

When you need to borrow money, you could sign a personal loan, which allows you to borrow for any purpose. But if you already have savings of your own in a 401(k), you may be more inclined to take out a loan against your balance.

The upside of taking out a 401(k) loan is that you’re borrowing money from yourself. And so when you make payments on that loan, you’re simply putting your own money back as opposed to padding an outside lender’s cash reserves.

But while it’s easy to see why you might find the idea of a 401(k) loan appealing, here are a few reasons why you may be much better off borrowing with a personal loan instead.

1. You won’t have to worry about an early withdrawal penalty

Failing to repay a personal loan can have consequences. You’ll risk costly fees and extensive credit score damage.

But if you fail to repay a 401(k) loan, it will be treated as a withdrawal from your retirement plan. And if that withdrawal happens before you reach the age of 59 1/2, you’ll be penalized 10% of the sum you’ve borrowed. So for a $10,000 loan, you’re looking at losing $1,000, just like that.

2. You might get more time to pay it off

The amount of time you get to repay a personal loan can vary, but often, you’ll have two to five years to repay one of these loans. Some lenders might even give you up to seven years to repay a personal loan.

Admittedly, you might get a good number of years to repay a 401(k) loan, too. But once you leave your company, that window could get whittled down to just a few months. And even if you don’t have plans to leave your job, you may be forced to leave if your company downsizes. That will still mean having to repay your 401(k) loan in short order or otherwise risk having your loan turn into a withdrawal, subjecting you to a penalty.

3. You won’t have to worry about being short on funds later in life

The money you borrow in personal loan form isn’t coming out of your personal cash reserves. As such, you don’t have to worry about it leaving you short on funds later in life.

If you take out a 401(k) loan you fail to repay, in addition to potentially facing a penalty, you’ll risk retiring with less money. And that’s a pretty big risk.

Many seniors find it difficult to hold down a job due to health or mobility issues. So a seemingly innocent loan-turned-withdrawal in your 30s or 40s could mean struggling financially in your 70s or 80s.

It’s easy to see why you may be inclined to borrow against your 401(k). But before you go that route, consider a personal loan instead. If you have great credit, you may find that you’re able to snag a pretty competitive interest rate on a personal loan targeted to those with higher credit scores. And if you shop around with different lenders, you might manage to eke out extra savings there, too.

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The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.Maurie Backman has positions in Target. The Motley Fool has positions in and recommends Target. The Motley Fool has a disclosure policy.

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