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Taking a loan can be an intimidating process. While it's a great way to secure access to large sums of money, defaulting on a loan can be damaging to one's financial portfolio and credit.
401k loans work a bit differently from traditional bank loans. Here's what you need to know about how your 401k loan will affect your credit score.
What are 401k Loans?
When you take a 401k loan, you're essentially borrowing money from your future self. These loans are drawn from your 401k retirement savings plan. While the restrictions depend on the nuances of your unique situation, you can typically borrow up to 50% of your savings.
It's important to understand that while you're effectively using your own money and that of your employer, you still need to pay it back with interest. A 401k loan is not the same as a 401k withdrawal, in which you permanently take the money out of your 401k (ideally for retirement).
Do 401k Loans Affect Your Credit Score?
The main benefit of a 401k loan is that they don't require a credit check to secure. Most traditional loans are dependent on your credit score. This aspect of a 401k loan makes it easier to secure for those with less than ideal credit.
Additionally, if you miss a payment or default on your loan, your credit score will be unaffected. That's not to say that there aren't serious consequences to defaulting on a 401k loan payback, but the credit bureaus won't hear about it. With traditional loans, missed payments and defaults will stay on your credit report for years.
When Should you Take a 401k Loan?
Taking a 401k loan could dramatically impact your financial future. Yet, there are many good reasons to take this approach. For example, you could use your 401k loan to pay off high-interest debt, so you can begin your credit repair journey and minimize interest payments. This is a good strategy if you can stick to a budget and your 401k repayment is more manageable than your existing debts.
Many people use a 401k loan to buy a home or pay for a large event, like a wedding or college tuition for their child. Again, the benefit of this option is low interest, repayment flexibility, and convenience.
However, you shouldn't rely on this option for all of your financing needs. If you have a poor credit score, it's worth investing your time and effort into improving it. The simple act of spotting an error on your credit reports and filing a dispute can have a big impact. Furthermore, putting financial management strategies in place will help you build more credit for future purchases. While a 401k loan doesn't negatively impact your credit score, it also doesn't improve your credit score.
What Impacts Your Credit Score
If you think a 401k loan is your only option, it's worth taking steps to improve your credit score. Even if you move forward with the 401k loan, this financial improvement strategy will set you up for success in the future.
Some of the things that negatively impact your credit score include:
- Late or missed payments - make minimum payments even if you can't pay down the debt, and ensure they're paid on time.
- Debt ratio - how much you're approved to borrow versus how much you actually use. Paying down existing debt will help.
- Collections or bankruptcy - these negative items will stay on your credit report for years and negatively impact your score.
- Hard inquiries - if a lender does a credit check for approval, it will slightly impact your score for a couple of years.
Identify which issues you struggle with and consider talking to a financial advisor for guidance.
401K Loan Tax Implications
So, what happens if you take a 401k loan and default on it? While this issue will have no impact on your credit score, it will impact your taxes. You will have to pay the income tax on the amount you defaulted on.
For example, if you took a $25,000 401K loan and only paid back $10,000 before defaulting, you'll be charged income tax on the remaining $15,000. If you can't pay it, the amount owing will be charged to your 401k, taking money away from your retirement savings. Additionally, if the default amount pushes you into the next tax bracket, you could pay more income tax over the year.
In summary, taking a 401k loan can be beneficial, especially for those with fair or poor credit. However, it's integral to pay it back— otherwise, you're robbing yourself.
