Do 401k loans affect credit?
When borrowing from your 401(k), you may be wondering how the 401(k) loan affects your credit and whether it appears on a credit report. Here is everything you need to know.
If you need to raise cash for a short-term liquidity need, a 401(k) is one of the first places you should consider. Taking a 401(k) loan can help you avoid the high-interest payday days or credit card loans, and instead borrow against your savings. Although some financial analysts describe 401(k) loans as an act of robbery against your retirement savings, a 401(k) loan provides greater convenience, speed, and repayment flexibility.
A 401(k) loan does not affect your credit score or debt-to-income ratio, since you are borrowing against your retirement money. A 401(k) loan is not technically a debt, and it is not considered when calculating your debt-to-income ratio. If you don’t pay the outstanding loan balance, you won’t owe any lender other than yourself. A 401(k) plan is not set up to offer lending services, and hence, the plan administrator cannot report the 401(k) loan activities to credit bureaus.
Will a 401(k) Loan Appear on a Credit Report?
When you apply for a 401(k) loan, the application process does not entail a credit check, and your credit score will not be considered to determine if you qualify for a loan. Since you already own the retirement savings, the lender does not pull your credit report to check your credit history.
With a traditional loan such as a personal loan, you must undergo a credit check to determine your creditworthiness. Any new loan is recorded in your credit report, which also affects your credit score. However, if you get approved for a 401(k) loan, the new loan is not recorded on your credit report. Also, if you default on the 401(k) loan, the plan administrator will not report the default to credit bureaus, hence it will not appear on your credit report.
Does a 401(k) Loan Affect Credit Score?
When you request a 401(k) loan, you can get approved quickly since there are no credit checks involved. Usually, a 401(k) loan does not involve an inquiry against your credit or trigger a dip in your credit score. Credit bureaus do not track 401(k) loan payments, hence your payment history will not appear in your credit report. If you miss out on a payment, the default will not be considered in your credit score calculations.
Although defaulting on a 401(k) does not affect your credit score, it can have other negative consequences. The unpaid 401(k) balance will be treated as an income for tax purposes, and you will be required to pay income taxes and a potential penalty if you are under 59 ½. The additional tax and penalties can make it difficult for you to pay your bills on time, which could have an indirect impact on your credit rating.
Does a 401(k) Loan Reflect on Your Debt to Income Ratio?
The debt-to-income ratio shows how much of your gross monthly income goes to making monthly debt payments. It is calculated by adding up your monthly bills and dividing the total by the gross monthly income. Lenders use this ratio to evaluate your credit risk.
Since a 401(k) holds your retirement savings, a loan from a 401(k) is not considered a debt and, therefore, it is not included when calculating your debt-to-income ratio. If you default in making timely loan payments, you won't owe any lender but yourself. The outstanding balance may be considered a deemed distribution, or offset against your 401(k) balance.
Some of the debts considered when calculating the debt-to-income ratio include mortgage payments, student loans, home equity loans, credit card loans, and auto loans. Lenders are interested in a debt-to-income ratio of less than 36% since it shows that a borrower has sufficient income relative to the monthly debt payments. In contrast, a high ratio shows that an individual has too much debt for the total income they earn every month.
What Happens When a 401(k) Loan Defaults?
When a default is on the horizon, you can decide to make a lump sum payment on the loan to avoid default. However, if you are cash-strained, you can let the loan default and deal with the consequences. Although the default will not be reported to credit bureaus, it will have steep tax implications.
The unpaid 401(k) loan balance is considered a distribution, and you will owe income taxes on the amount. If this distribution occurs in a period of high earnings, you could pay a significant tax amount on the distribution. If you are under 59 ½, you could be required to pay an additional early withdrawal penalty. Also, you will have removed a sizeable chunk of money from your retirement savings, and you will never be able to return the money back to its tax-deferred status.