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Understanding 401(k) Loans and Personal Loans: A Comprehensive Guide

When you need to borrow money for a large expense or an emergency, you have several options. Two common choices are 401(k) loans and personal loans. Each has its own benefits and drawbacks, so the right one for you depends on your specific needs and preferences. In this article, we’ll explore both options to help you make an informed decision.

What Is a 401(k) Loan?

A 401(k) loan allows you to borrow money from your retirement savings. If your 401(k) plan administrator offers this option, the application process is often straightforward. You can typically request the loan by logging into your account through your plan administrator’s website and specifying the amount you want to borrow. You may take up to 50% of your vested account balance, up to a maximum of $50,000, within a 12-month period.

Once authorized, the money is usually included with your next paycheck and can be used for virtually any purpose. You’ll need to repay the loan within five years, with interest, unless you use the funds to buy a primary residence. The interest rate is determined by the fund administrator and is typically calculated by adding one or two percentage points to the current prime interest rate. Payments are made at least quarterly. However, if you lose or leave your job, the entire loan balance may become due by the tax-filing deadline for the year you received the distribution.

Pros and Cons of 401(k) Loans

Pros

• Easy application process: No credit check required.
• Relatively low interest rate: Interest goes back into your own account.
• No credit impact: The loan is not reported to credit bureaus.

Cons

• Loss of potential earnings: You miss out on gains if the money had stayed invested.
• Risk of default: If you lose or leave your job, you may need to repay the loan quickly.
• Limited availability: Only available if your employer allows it and you are still employed there.

What Is a Personal Loan?

A personal loan is a type of loan provided as a lump sum and repaid in installments over time, usually two to seven years. This type of financing is very flexible because you can use the funds for nearly any purpose, such as consolidating high-interest debt or making home improvements. Personal loans typically range from around $1,000 to $50,000, with some going as high as $100,000.

The application process is more involved compared to a 401(k) loan. You’ll need to find a lender, submit a loan application, and authorize a hard credit pull. The lender may also need documentation, such as tax forms and paystubs, to verify your income. Additionally, some lenders restrict how you can use the loan, so you’ll need to check the terms and conditions.

Pros and Cons of Personal Loans

Pros

• Potentially high loan amounts: You may be able to borrow more than with other options.
• Won’t affect your assets: Personal loans are often unsecured.

Cons

• Impacts your credit: Applying for a personal loan adds a hard inquiry to your credit reports.
• Relatively high costs: The average interest rate on a 24-month personal loan was 12.35% as of November 2023.

Should I Get a 401(k) Loan or a Personal Loan?

Both 401(k) loans and personal loans are viable options when you need to borrow money. Borrowing from your retirement account is typically quick, requires no credit check, and comes with lower costs compared to a personal loan. However, a personal loan may be the way to go if you need to borrow a larger amount, want a longer repayment term, or are uncomfortable with the thought of risking potential stock market gains.

When making your decision, consider:

• The amount you need to borrow
• A loan term that works for you
• Your job stability
• Your credit history
• How much you’ve saved in your 401(k)

Alternatives to 401(k) Loans and Personal Loans

If neither a 401(k) loan nor a personal loan seems right for you, consider these alternatives:

• Home equity loans: Borrow a lump sum of money that you repay in installments over time with interest. Your home acts as collateral.
• Home equity lines of credit: Access a revolving line of credit that you can draw from as needed and then repay with interest.
• Introductory 0% APR credit cards: Offer a low interest rate on purchases, balance transfers, or both for a set period of time.

The Bottom Line

Borrowing money is a big decision, and the financing you choose can affect your monthly payments, borrowing costs, and credit. A strong credit history may boost your approval odds and help you receive good loan terms. Checking your credit score and report can help you see whether you have room to improve.

For any mortgage service needs, contact O1ne Mortgage at 213-732-3074. Our team is here to help you find the best financing options for your situation.

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