What's the interest rate on a 401k loan?

If you are in a financial emergency, and no other source is available, you could consider tapping into your retirement money, at least temporarily. A 401(k) allows participants to borrow against their retirement money, subject to certain restrictions provided by the IRS. If the loan request is approved, you must pay back the money to your account over time, with interest.

The interest rate charged on a 401(k) is usually a point or two above the prime rate, but it may vary. For example, if the prime rate is sitting at 4%, the 401(k) loan interest rate may range from 5% to 6%. The IRS requires that qualified retirement plans charge a commercially viable interest on the 401(k). The interest rate charged is not affected by your credit score, since there are no credit checks involved, and the 401(k) is not reported to credit bureaus.

How much interest do you pay on a 401(k) loan?

When you borrow against your retirement savings, the interest rate you pay on the loan will be determined by the 401(k) plan, based on the current prime rate. The prime rate is the rate that individual banks charge their most creditworthy customers who are less likely to default. The prime rate is anchored on the federal funds rate. If the current prime rate is 4%, the 401(k) plan may add one to two points above this rate. Therefore, you can expect to pay an interest rate of 5% to 6%, but the rules may vary across different retirement plans.

The 401(k) plan sets the term of the 401(k) loan including how much you can borrow, the interest rate, and the repayment period. Usually, you can borrow up to 50% of your retirement money, or a maximum of $50,000. The 401(k) loan will be repaid on an amortizing basis, with fixed repayments spread over a specific period, usually not more than 5 years unless you are borrowing to pay down payment for your primary residence. Each loan payment contains a portion of the principal and interest, and the funds are deposited into your 401(k) account.

401(k) Loan Fees

When borrowing against your retirement savings, you will incur certain costs to process the 401(k) loan. Most 401(k) plans charge a one-time origination fee that ranges from $50 to $100, regardless of the amount of loan. You may also incur a loan service fee of $20 to $50. For example, if you borrowed $1000, you can expect to pay about $75, which means you will be losing 7.5% of the loan amount before the money is deposited into your account.

Taxes on 401(k) Loan Interest

401(k) plan contributions are made on a pre-tax basis, and this means that you don’t pay taxes when you contribute to the plan. Instead, you pay taxes in the future when you withdraw money in retirement. However, unlike 401(k) contributions, you must use after-tax dollars when making loan payments, including the interest portion of the loan. This means that the interest will be taxed twice since you will also pay income taxes when you take a 401(k) distribution in retirement. However, the interest portion is a modest amount, and the impact of double taxation will be negligible.

Is it a good idea to take a 401(k) Loan?

A 401(k) can be a good or bad idea depending on the purpose for which you are borrowing the money. For example, if you are borrowing to fund home improvements such as roof replacement, it can be beneficial since it increases the value of the property. If you are planning to sell the property, the additional value obtained from the home improvements can help offset the forgone retirement savings.

Also, a 401(k) can be beneficial if you are borrowing to repay a high-interest debt. For example, if you have a credit card debt with high interest, you can take a 401(k) loan to offset the outstanding debt. A 401(k) loan has a lower interest rate than a credit card loan, and it can help you reduce the amount of interest you would otherwise pay on the credit card loan.

On the downside, it will be a bad idea to borrow a 401(k) loan for entertainment purposes. For example, borrowing a 401(k) loan to buy a birthday gift for a friend or family member is a bad idea, since you will not derive any benefit from it. Therefore, you will be better off leaving the money in the 401(k) to continue compounding, and use other sources of cash to buy the gift.