What are the 401k loan interest rates?

When you take a 401(k) loan, you are tapping into the retirement savings you have been setting aside for retirement. A 401(k) loan is different from a traditional loan since you are borrowing your own money. Also, the 401(k) loan interest you pay goes back to the 401(k) account.

The interest rate on a 401(k) loan is based on the prime rate, and it adds one or two points above the prime rate. The prime rate is determined by individual banks, using the federal funds rate as a benchmark. The loan interest goes back to your 401(k) account to help replenish the account balance. Typically, the 401(k) loan interest is usually lower than the interest you pay on other types of loans such as personal loans and credit card loans.

What 401(k) interest rate do you pay on a 401(k) loan?

401(k) loan interest is based on the prime rate. This is the rate that commercial lenders use to provide credit to their most creditworthy creditors. When determining the 401(k) loan interest rate, 401(k) plans add one or two points higher than the prime rate.

For example, if the prime rate sits at 4.5%, the 401(k) plan will set the 401(k) loan interest rate at between 5.5% and 6.5%. The interest rate will be the same for every participant who borrows a 401(k) loan, regardless of their credit rating.

The prime rate also forms the basis of other interest rates such as interest rates for mortgages and personal loans. However, the interest rate charged on a 401(k) loan may be lower than the rate you could get with a personal loan.

What is the Prime Rate?

The prime rate is the index that commercial banks use to set interest rates for creditworthy corporate clients. It uses the federal funds rate as its benchmark.

The Federal Reserve does not set the prime rate, but it is instead set by individual banks. Banks use the federal funds rate as the starting point for setting the prime rate for loans. Generally, the prime rate is usually about 3% above the federal funds rate.

Usually, the loan interest rate provides a way for lenders to cover the costs associated with lending. The interest compensates the lender for assuming the risk of extending credit based on the borrower's credit history. The interest rate is usually a few points above the prime rate, and this forms the underlying base for calculating interest rates. If the federal funds rate changes, this change is reflected in the prime rate, and subsequently, on the interest rate charged on 401(k) loans.

Where does 401(k) interest go?

The good thing with 401(k) loan interest is that you pay the interest back to your 401(k) account. This helps replenish the money you took from your 401(k) when taking the loan.

A drawback with the 401(k) loan interest is that you pay the money using after-tax dollars, which means that you are paying taxes on the money before putting the money in your 401(k) account. You will also owe taxes when you withdraw funds in retirement. Therefore, you will pay taxes twice on the loan interest you pay.

Does your credit score affect your 401(k) interest rate?

Your credit score does not determine the interest rate you pay on a 401(k) loan. Typically, your credit score does not affect your chances of getting approved for a loan, and you may be allowed to borrow from your 401(k) even with bad credit. Once the plan administrator sets the interest rate for 401(k) loans, this rate remains the same for all participants regardless of their credit scores.

Should You Get a 401(k) Loan?

Before taking a 401(k) loan, you should consider whether a 401(k) loan makes sense for your situation. Generally, if you have poor credit, a 401(k) can save you from high-interest debts.

A 401(k) loan charges a lower interest rate than other types of loans such as personal loans and credit cards, and you can expect to pay one to two percentage points above the prime rate. However, personal loans and credit cards can charge as high as 20% or more if you have an average credit score. Hence, you will be saving money when you borrow from 401(k) instead of taking a high-interest loan.

Before taking a 401(k) loan, you should consider the cost advantage of the 401(k) loan. You should compare the lost investment earnings against the interest you will pay back to the 401(k). The cost advantage is determined by taking the loan interest less any lost investment gains. If the cost advantage is negative, a 401(k) loan may be less desirable. However, if the cost advantage is positive, it means a 401(k) loan can be an attractive option since the loan interest exceeds the investment earnings.