Many 401(k) plans allow users to borrow against their retirement savings. It’s a relatively low-interest loan option that can help cover a large expense, but tread lightly. Getting a 401(k) loan can mean long-term retirement losses or penalties if you’re unable to repay the loan.

What is a 401(k) loan?

Employer rules vary, but 401(k) plans typically allow users to borrow up to half of their retirement account balance or $50,000 — whichever is less — for a maximum of five years. 

After other borrowing options are ruled out, a 401(k) loan might be an acceptable choice for paying off high-interest debt or covering a necessary expense, but you’ll need a disciplined financial plan to repay it on time and avoid penalties.

Pros and cons of a 401(k) loan

Consider these pros and cons before borrowing.

Pros

• 401(k) loans usually have single-digit interest rates, making them cheaper than credit cards. Interest typically equals the prime rate plus one percentage point.
• The interest you pay goes back into your own account.
• There’s no credit check or impact to your credit score.

Cons

• It derails your retirement savings, sometimes significantly.
• If you leave your job, you must repay the loan quickly.
• Risks include tax consequences and penalties.

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The true cost of a 401(k) loan

Any money you borrow from your retirement fund misses both market gains and the magic of compound interest.

According to Vanguard’s 401(k) loan calculator, borrowing $10,000 from a 401(k) plan over five years means forgoing a $1,989 investment return and ending the five years with a balance that’s $666 lower. This assumes you pay 5% interest for the loan and the investments in the plan would have earned 7%.

But the cost to your retirement account doesn’t end there. If you have 30 years until retirement, that missing $666 could have grown to $5,406, according to NerdWallet’s compound interest calculator (assuming that same 7% return, compounding monthly).

Moreover, you may reduce your 401(k) contributions while making payments on a loan from the plan. This further sets back your retirement savings.

401(k) loans are tied to your company

If you leave your job while repaying your 401(k) loan, you must pay the balance either immediately or within a shortened time frame. Some plans require immediate repayment if you leave before the loan is paid.

If you’re unable to repay the loan, the IRS will consider the unpaid amount a distribution and count it as income when you file that year’s taxes. You’ll also incur a 10% early withdrawal penalty if you’re under the age of 59 1/2.

Should you use a 401(k) loan to pay off debt?

Before you get a 401(k) loan to pay off debt, consider other options that won’t impact your retirement savings.

Debt consolidation: Debt consolidation allows you to roll multiple high-interest debts to a balance-transfer card or personal loan with a lower interest rate. You then have a single monthly debt payment and less total interest cost.

Debt relief options: If you can’t pay off unsecured debts — credit cards, personal loans and medical bills — within five years, or if your total debt equals more than half your income, you might have too much debt to consolidate. Your best option is to consult an attorney or credit counselor about debt relief options, including credit counseling.

Bankruptcy: Chapter 13 bankruptcy and debt management plans require five years of payments at most. After that, your remaining consumer debt is wiped out. Chapter 7 bankruptcy discharges consumer debt immediately.

Unlike consumer debt, a 401(k) loan isn’t forgiven in bankruptcy.

401(k) loan alternatives

Because of the risks associated with 401(k) loans, first consider alternative financing options.

Alternatives for large expenses

Personal loans: You can use a personal loan for almost anything, including debt consolidation, home repairs, emergencies and medical bills. Loan amounts are from $1,000 to $100,000, and rates are 6% to 36%. They’re usually repaid in monthly installments over a term from two to seven years.

These loans are unsecured, so there’s no collateral required. A lender uses financial and credit information to determine whether you qualify and your loan’s annual percentage rate.

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on NerdWallet

Home equity loans and lines of credit: A home equity loan or line of credit is a low-interest way to cover urgent home repairs or other emergencies. Depending on which you choose, you can typically borrow up to 80% of the home’s value, minus what you owe on the mortgage. Rates are often in the single-digits, and repayment terms are from 10 to 20 years.

Both home equity loans and lines of credit require you to use your home as collateral for the loan, meaning the lender can take it if you fail to repay. The biggest difference between these financing options is their borrow-and-repay structures.

0% APR balance transfer credit card: Another option is to move high-interest debt to a balance transfer card with a zero-interest promotional period. You usually need good or excellent credit to qualify (690 or higher credit score), and the amount you can transfer depends on the credit limit the card issuer gives you. If you qualify, you must pay the balance during the interest-free promotional period — usually 15 to 21 months — to avoid paying the card’s (often high) regular APR.

Alternatives for small expenses

Family loans: It’s worth asking a trusted friend or family member for a loan to help bridge an income gap or cover an emergency. There’s no credit check with this option and you can draw up a contract with the lender outlining interest and how the loan will be repaid.

Cash advance apps: Cash advance apps let users borrow up to a few hundred dollars and repay it on their next payday. These advances can be a fast way to cover a small, urgent expense. There’s no interest, but the apps often tack on fees for fast funding and ask for optional tips.

Buy now, pay later: If you’re repairing a car, replacing a laptop or buying a new mattress, the merchant may offer buy now, pay later plans. This payment plan lets you split up a purchase into smaller, usually biweekly payments. Having bad credit (a score lower than 630) may not prevent you from qualifying because there’s usually only a soft credit check.