Financial emergencies are a common occurrence. Worse, these emergencies can happen when you barely qualify for regular bank or credit union loans. Perhaps your credit score is weak, or you have no collateral to put up as security.

In such a situation, a 401(k) loan can save you from the financial mess. Unlike regular loans, the 401(k) loan gives quick access to funds as long as you have a vested account balance. You won’t need a clean credit score or collateral to secure the 401(k) loan.

How do 401(k) Loans Work?

A 401(k) loan typically lets you borrow money from your retirement savings scheme. Since you will be borrowing your money, the payments and interest rates will go back to your retirement savings account – not the provider.

Unlike traditional loans from banks and credit unions, securing a 401(k) loan is straightforward. You need to approach your employer and notify them of your intent to get a 401(k) loan. After the nitifiation, your employer will liaise with your plan administrator to process the loan.

The processing time takes around one to two weeks. However, you could get your 401(k) loan approved sooner if your plan administrator is quick and your loan application captures all details correctly.

The IRS has capped 401 (k) loan limits at $50,000 or 50% of your vested account balance, whichever is lower. The limits from the IRS ensure that you can access funds to sort emergencies and still save for your retirement.

Without the limits, you could deplete your retirement savings, defeating the purpose of a 401(k) plan.

How 401 (k) Payback Works

Typically, you have to repay your 401(k) loan within five years. Repayment schedules vary depending on the loan terms from the administrator managing your 401(k) plan. Your retirement plan administrator will most likely schedule weekly, biweekly, monthly, or quarterly repayments.

The 401(k) loan providers charge an interest rate based on the prime rate — a rate banks charge their most creditworthy clients. However, one good thing is that your 401 (k) interest goes to your retirement savings account. Thus, you lose nothing, even if the loan had a higher interest rate.

While the repayment period for a 401(k) loan is typically five years, your provider will ask you to repay the entire outstanding amount if you leave your current job. As such, the 401(k) loan might not be ideal if you are expecting a job change or layoff.

How Penalties for Failure to Pay Your 401(k) Loan Work

Unlike regular loans, defaulting on a 401(k) loan does not impact your credit score. The reason is that getting a 401(k) loan is akin to borrowing from your retirement savings. Your provider loses anything if you default payments.

Furthermore, since it is unsecured, you don’t risk collateral repossession with a 401(k) loan. Nonetheless, you need to repay the loan as per terms, lest you expose yourself to a couple of financial disadvantages.

For instance, your plan administrator will consider the unpaid balance as an early distribution of retirement benefits. As a result, if you’re under 59.5 years old, you’ll likely face a 10% early withdrawal penalty.

The Bottom Line- Should I Take a Loan From My 401(k)?

Taking a loan from your 401(k) isn’t a bad idea when you need emergency funds. The loan provides quick access to funds, saving you the stress of lengthy approvals. Moreover, the 401(k) loan doesn’t impact your credit score, and the interest paid goes into your retirement account.

While a 401(k) loan provides financial assistance in times of need, you have to repay it on time. Otherwise, providers will consider it an early distribution, attracting a 10% early withdrawal penalty plus income taxes.