Life is full of unplanned and unexpected moments. While spontaneity can sometimes be a welcome occurrence, it isn’t always – especially when the unpredictable ends up taking a toll on our wallets. If you find yourself in need of money to pay for unplanned expenses, the good news is there are plenty of options you can take advantage of to obtain the funds you’re looking for. Each option has its own pros and cons that are worth considering, so in this article, we’re going to explain the benefits and limitations of two common ways people get funds to pay off debt: borrowing from their 401k or taking out a short-term personal loan.

Before we get into the pros and cons of these options, we’ll start by giving a brief explanation of what a 401(k) is.

What is a 401(k)?

A 401(k) is an employer-sponsored retirement plan that allows you to invest a given portion of your salary into long-term investments. Companies that offer 401(k) plans generally offer different investment options, ranging from aggressive growth funds to conservative income funds. If you’re fortunate, your employer may even match a percentage of the contribution you make to your 401(k). You heard that right – some employers will essentially give you “free” money for investing in a retirement plan.

Here’s the takeaway: With a 401k, you sock away a small amount of your salary every paycheck over the duration of your career. This money builds interest over time, and when it comes time to retire, you can withdraw the money and live off your investment.

Should I Borrow from my 401(k)?

Borrowing from a 401k to pay off debt may seem like an attractive option, but it comes with a major tradeoff – a decreased retirement fund. In addition to having less savings to hold you over during your golden years, you could also be slammed with penalty fees for withdrawing from your 401(k) early. According to U.S. News, if you withdraw from your 401(k) before the age of 59 ½, you’ll be required to pay a 10% early withdrawal penalty in addition to income tax on the distribution. While it may be easy to borrow from your retirement fund, it’s wise to consider the post-retirement implications borrowing from this source could cause.

 What’s Good About a Personal Loan?

Personal loans may offer quick funds that can help you pay for life’s emergencies and make stressful situations more manageable. With a personal loan, you can borrow a fixed amount of money for a variety of reasons, from debt consolidation, to home improvement, to medical bills – the list goes on.

There are a few reasons borrowing with a personal loan could be a smarter financial decision than borrowing from your 401(k), but everyone’s situation is unique. Below, you’ll see a list of pros and cons for each option, and below that, we’ll include some context for each of the points listed. By closely considering the benefits and limitations of these borrowing options, you can ensure that you’ll be able to make the right call for your specific needs.

What’s the Better Choice: A Personal Loan or Borrowing from Your 401(k)?

Taking out personal loan

PROS:

  • Obtain funding without incurring an early withdrawal penalty
  • Won’t jeopardize retirement savings
  • Money could be in your account in as little as 1 day

CONS:

  • Application necessary
  • Minimum credit score required
  • Could have high-interest rates depending on credit score
Borrowing from 401k

PROS:

  • Generally simpler application process
  • No credit check required
  • Typically lower interest rates

CONS:

  • Funds withdrawn from 401(k) lose protection from bankruptcy
  • Penalty fees and taxes for withdrawing early
  • Generally takes 1 -2 weeks to receive funds

Benefits of Choosing a Personal Loan

Penalties

A major benefit of borrowing with a personal loan over a 401(k) is that you could receive the funds you need without paying withdrawal penalties. As we mentioned earlier, if you borrow from your 401(k) before you turn 59 ½, the funds you take out will be subjected to income tax and a 10% penalty fee. As soon as you turn 59 ½ you can access this money without penalty, so this benefit may not play a huge role in your decision-making if you’re of this age. With that said, it’s a smart idea to consult a tax professional when making major decisions like this to ensure that you’re doing what’s best for your financial health.

Source of Funds

Another major benefit personal loans provide over 401(k)s is related to the source of the money you’re borrowing. This is going to sound like common sense, but it’s worth mentioning because it’s one of the bigger downsides to borrowing from your 401(k): Retirement savings are there for you to keep for your future. In a world where many people struggle to support themselves after retiring from the workforce, it can be a good call to preserve these funds at all costs. Taking out a personal loan, on the other hand, will not jeopardize the savings you have for retirement.

Timeliness

A notable pro that you may not have considered for personal loans is that they’re timely – if a sudden, unexpected expense pops up, you could have the money you need within 1-3 business days. According to Sapling, receiving the funds you withdraw from your 401(k) could take 1-2 weeks or even longer in some cases. If you find yourself in a situation where you need money fast, personal loans could be a better option.

401(k) Funds Lose Protection from Bankruptcy

Something you may be unaware of is the fact that the funds in your 401(k) are protected from bankruptcy. If you file for bankruptcy, federal law states that the money in your retirement plan cannot be touched by creditors and must remain in your name. However, the money you take out of your 401(k) is not protected in the same way; if you use a 401(k) loan to pay off debts and still remain in financial trouble, you’ve spent protected savings that could’ve been your safety net. At the end of the day, it’s a smarter financial decision to file for bankruptcy with retirement savings safe in the bank than using those funds to pay down debts. Not only will you avoid spending the money you’ll need for tomorrow, but you’ll also have the added benefit of getting the most return from compounding interest on your investment.

Benefits of Choosing a 401(k) Loan

Application Requirements & Interest Rates

It could be said that 401(k)s have a leg up on personal loans when it comes to application requirements. Applying and getting approved for a personal loan with competitive interest rates requires that you have a decent credit score and credit history. While loan applications may be required for 401(k) loans, they’re not subject to the same kind of underwriting as personal loans. Credit checks are not required, and while there are interest rates, they’re generally much lower than those of a personal loan.

Loan Repayment Options

This could be a benefit or a detriment depending on your personal preference, but there are notable differences in how you repay a personal loan vs. a 401(k) loan.

When you apply for a personal loan, you generally get to select your loan term from a list of available terms, and agree to make fixed monthly payments to pay back the amount you borrowed. 401(k)s are different – you’ll generally have a total of 5 years to pay back your loan (though there are no prepayment penalties) and there are multiple options for repayment.

You can pay back a 401(k) loan by making monthly payments similar to a personal loan, or you can opt for payroll deductions to pay off your balance. With payroll deductions, a percentage of each of your paychecks will be skimmed off the top and put back into your 401(k) account. Depending on your situation and preferences, having funds automatically deducted from your paycheck could be an easier way to repay a loan.

Should You Take Out a Personal Loan or Borrow from Your 401(k)?

While there are a few benefits to borrowing from your 401(k) as opposed to obtaining a personal loan, this is something you should keep in mind:

Your 401k is not an emergency fund or a source of discretionary spending.

As we mentioned earlier, these funds are meant to support you through your golden years; if a personal loan can solve for your needs, it’s the better, less risky option. Why jeopardize your retirement savings if you don’t have to?

When you find yourself faced with life’s unexpected expenses, a personal loan could be exactly what you need to pay off debt and get back to focusing on your financial goals.