When you are in a pinch, you may want to consider taking out a 401(k) loan. With a 401(k) loan, you can buy a house, pay bills, or pay off your debts. However, remember, if you are not careful, a 401(k) loan can also be a boomerang. By the way, what is the interest rate on a 401(k) loan? Well, in this article, we will answer that question. And, we will also share some information related to 401(k) loans.
The Interest Rate on a 401k Loan
When you want to take out a 401(k) loan, one of the most important questions you might ask is what is the interest rate on a 401(k) loan. You do not want a 401(k) loan to put a strain on your mind and worsen your finances. Knowing the interest rate charged on a 401(k) loan is important. You do not want to regret taking out a 401(k) loan.
So, what is the interest rate on a 401(k) loan? You should know that the interest rate on a 401(k) loan is lower than other retail loans. Typically, on a loan, the prime interest rate is plus 1% to 2%. We get information that in November 2023, the prime interest rate is 8.50%, which means the interest rate on a 401(k) loan will be around 9.50% to 10.50% APR. It is also on your plan administrator. Now that you know the interest charged on 401(k) loans, do you intend to take out a 401(k) loan? If yes, make sure it is your best option.
How Does a 401(K) Loan Work?
The way a 401(k) loan works is just like borrowing money from your own account. Therefore, when you decide to take out a 401(k) loan, there will be no credit check. Once you have successfully withdrawn money from your 401(k), you can repay the balance you owe plus interest. Make sure you make the payments within a maximum of five years. The sooner the better. However, if you change jobs, you may be required to make payments in less than five years. Remember that the Internal Revenue Service (IRS) and your employer have strict borrowing rules. Of course, you must follow those rules to avoid the 10 percent early withdrawal penalty and income tax on the amount of the balance withdrawn.
What Are 401(K) Loans Commonly Used For?
If you take out a 401(k) loan, you can use that money for living expenses, paying bills, or whatever you need. If you are under 59 ½ years old now, you can avoid early withdrawal penalties and taxes. This loan allows you to take out up to 50% of your approved account balance, up to a maximum of $50,000. However, you can borrow up to $10,000 if 50% of the approved account balance is less than $10,000. Once you take out the loan, you must repay your loan within five years. But if you change jobs, you need to repay your loan in less than five years.
Commonly, 401(k) loans are used for:
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- Pay off IRS debt
- Avoiding foreclosure or eviction
- Pay medical bills
- Cover an emergency
- Buying a home
Apparently, a 401(k) loan is a better idea than an early withdrawal. But you should think carefully before taking out such a loan. Understand how 401(k) loans work, the rules and any information related to 401(k) loans.
Rules of a 401(K) Loan
Here are several 401(k) loan rules:
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Loan amounts
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For the loan amount, you will be able to borrow money up to 50% or up to $50,000 of your vested account balance. However, if 50% of your vested account balance is less than $10,000, then you can only borrow money up to $10,000.
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Repayment
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For 401(K) loan repayment, you are required to repay the loan in equal payments every month or at least every three months for a period of five years. You cannot exceed the five-year time limit. If you are unable to repay your loan, it will be considered a distribution. As a result, you will have to pay an early withdrawal penalty of 10%. And, you will also have to pay taxes on the balance.
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Repayment terms
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As we said in the previous paragraph, you must repay the 401(k) loan within a maximum of 5 years. However, if you took out a 401(k) loan to buy a primary home, you may get an extension. The repayment period of your 401(k) loan will likely be extended beyond 5 years.
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Spousal approval
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Generally, 401(k) plans do not require your spouse to approve a loan or distribution, however, you should discuss with your spouse to ensure that taking a 401(k) loan is a good idea.
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Loan fees
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To get a 401(k) loan, you must pay an initial fee. Some other loans also apply an annual fee for every year you have not paid off your loan in full. For instance, Merrill Lynch charges an initial fee of $75 and an annual fee of $75. The cost of the loan may vary.
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Interest
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Just like any other loan, you will also have to pay interest on the borrowed amount in addition to paying the principal balance. Usually, the plan administrator sets the amount of interest you must pay. However, it is also based on the prime interest rate. For example, a plan charges 1% plus the prime interest rate. Nevertheless, the interest payments will go into your own account.
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Remain with the same employer
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There is a rule that you must remain with the same employer. So, during the repayment period, you must remain with the same employer to maintain your 401(k) loan. If you are laid off, fired, or decide to stop working, then the remaining balance of your loan will be due immediately. However, it also depends on the employer’s policy. To avoid that, before the tax filing deadline, you should immediately roll over the loan with the outstanding balance into a qualified retirement plan. The bad news is that you may be required to repay the balance to avoid tax consequences and penalties for making early withdrawals.
For note: Just like any loan you take from a bank, you must repay your 401(k) loan with after-tax funds. Also, when you retire, you must pay taxes when you withdraw the funds. In essence, to spend money that has been tax-deferred, you must pay taxes on it. Fortunately, the interest you pay on the 401(k) loan will be yours.
How to Get a 401(K) Loan?
Below we will explain how to get a 401(k) loan:
Step 1: Contact your employer
The first thing you should do when you want to get a 401(k) loan is contact your employer. Usually, employer retirement plans have an online system that stores account info and self-service options. From there you will be able to apply for a 401(k) loan. Alternatively, you can also contact the employee benefits center and ask someone to explain how the process works.
Step 2: Review your balance
Then, you should review your balances. Try crunching the numbers for a 401(k) loan. You can use a retirement plan loan calculator to consider the cost of the loan. Do this properly and carefully as it will affect your finances in the future.
Step 3: Determine the amount of money you want to borrow
Make sure you choose the loan amount that you need. Please note that you cannot borrow more than 50% or up to $50,000 of your existing account balance. However, if 50% of your existing account balance is less than $10,000, then you are only allowed to borrow up to $10,000.
Step 4: Understand the repayment terms, interest rates and loan fees
You should know and understand the repayment terms, interest rates and loan fees. To do this, you can note down the details of upfront fees charged, interest rates charged, loan fees, and how much money will be deducted from your paycheck to repay the 401(k) loan. In addition, you should also review the plan’s disclosures thoroughly.
Before finalizing the loan documents, try to answer the following questions:
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- Do the 401(k) loan payments fit into your budget?
- Do you have money in reserve to repay the 401(k) loan if you are suddenly laid off from your job?
- Will you have the time and resources to replenish your retirement savings?
- Is this really your only option? What alternatives are you not considering?
Answer the questions above according to your current situation and condition as truthfully as possible. Make sure that taking a 401(k) loan is indeed the best solution for you.
What If You Cannot Repay a 401(K) Loan?
If you are unable to repay the 401(k) loan, then the remaining loan balance that you have not repaid will be added to your gross annual income. As a result, you will have to pay taxes for that year. In addition, if you were under 59 ½ when you took out the loan, then you will also have to pay an additional 10% penalty for early withdrawal. However, if you remain employed with the company you work for, then it is unlikely that you will default. You will always be able to repay your loan as the payment is deducted directly from your salary.
Yeah, we indeed cannot predict what will happen next in our lives. Likewise with your job, you will not know how long you can work at the company. For example, if you are fired from your current job, and you did not put the loan into a qualified retirement plan, then you will be required to repay it in full. If you cannot do so, then you will be in default. For instance, if you put the balance into an Individual Retirement Account (IRA), make direct payments immediately. If you stop making payments, you are in default.
Pros and Cons of the 401(k) Loans
Before you take out a 401(k) loan, make sure you know the pros and cons of a 401(k) loan. By knowing this information, you can make the right decision.
Here are pros of a 401(k) loan:
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Lower interest rate
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401(k) loans have lower interest rates compared to other retail loan options. As we said earlier, the interest rate on 401(k) loans is around 9.50% to 10.50% APR, depending on your plan administrator.
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Relatively fast funding
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Many people like this loan because of its fast funding. By the time you get your next paycheck, you can see the loan money in your account.
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No credit check
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401(k) loan is the only loan where there is no credit check. If you have bad credit, this type of loan is the best option for you.
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Automatic repayments
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401(k) loan repayment is easy. You do not have to deposit your money to make the payment because the 401(k) loan payment is taken directly from your paycheck.
Here are cons of a 401(k) loan:
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Limited 401(k) loan amount
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Some people do not choose this loan because of its limited loan amount. Remember that the Internal Revenue Service (IRS) limits the amount of 401(k) loans to 50% of the balance you have. This means that you cannot borrow more than that.
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Potential taxes and penalties
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If you are unable to repay the 401(k) loan, for instance due to job loss, then you will have to pay taxes as regular income. In addition, you will also have to pay an additional 10% on the distribution amount, if you were under 59 ½ years old at the time of taking out the loan.
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Loan fees
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There are loan fees that you must pay to take out a 401(k) loan. Your employer may charge an initial fee, an annual fee, or a default fee if you cannot repay the loan.
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No protection in bankruptcy
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Bankruptcy filings do not apply to this type of 401(k) loan. That means, no matter how difficult your finances are, you will still have to repay the loan. However, on the plus side, your money balance in your 401(k) is protected in bankruptcy.
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Reduces potential gains
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A 401(k) loan can reduce potential gains. According to Merrill Lynch, a $10,000 loan on a $50,000 balance that increases 5% per year could cost you nearly $13,000 in lost profits over 5 years.