Having a retirement plan is one of the better actions you can take in life. You'll want to be as comfortable as possible entering into your later years so that you can enjoy life to the fullest. However, it's not uncommon for each of us to encounter financial difficulties along the way, which may prompt you to take out a loan.

If you're aiming for debt consolidation, want to renovate your home, or just need some spare cash to bridge turbulent times, there are a few options available to you. You can borrower against your 401(k), or you can take on a personal loan. Both of these options have their benefits, and both have their flaws.

So what are the main differences between personal loans and 401(k) loans? Which is the better option when it comes to personal finance matters? This article will cover all vital aspects of 401(k) loans and personal loans, giving you a better foundation for determining which path is best for you.

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What is a 401(k) Loan?

Before we define what a 401(k) loan is, we need to know what 401k stands for. A 401(k) is a specific retirement savings plan that many people use to grow their nest egg for retirement. The primary benefit of 401(k)s are that they are taken out pre-tax, meaning your contributions are taken from your paycheck before taxes are deducted! Those dollars aren't tax free, so don't get too excited. With a 401(k), you're taxed at final when those funds are distributed. The key is that you'll get years of accrued earnings so that you can grow that retirement balance as high as possible.

Additionally, some employers may even offer you a 'company match'; the company's financial contributions are equal to your own contribution amount for the 401(k). These sorts of deals are exceptional for employees because it speeds up the entire 401(k) process and helps guarantee them a healthy retirement savings fund.

Now that we've explained what 401(k) stands for, it's time to talk about 401(k) loans. In essence, a 401(k) loan is one where you're borrowing your own money. You are your own lender!

You are still obligated to repay that loan, but the interest rate is either zero or very low. It's worth noting that this interest rate technically means you'll pay yourself back more than you've borrowed - which isn't necessarily a bad thing, but there are lots of laws and rules around that - a topic for another time.

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Should you borrow money from your 401k account?

Debt repayment works slightly differently with 401(k) loans so the whole situation is fairly unique. There is space for flexible repayment terms and impeccable interest rates, making them a perfect choice for quickly getting money. But is a 401(k) loan as good as it sounds and how does it compare to a traditional personal loan regarding interest rates and the effect on your credit history? Let's find out!

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401k loan pros

• Quick approval of loan - 401(k) loans aren't susceptible to credit checks and as such, your previous loan payments and other credit history details are not needed here. Overall, you can expect a 401(k) loan to be approved fairly quickly, sometimes in just a few days. Loan applications are simple and quick and are more administrative than anything.
  
• Interest payments go back to you - Any money you take out of your 401(k) account eventually goes back into it. So, when you're paying interest for the 401(k) loan, you're actually just depositing the money you took out back into your 401(k) account. If you don't want to pay those big banks even more money, this is an interesting path to go!
  
• Lower interest rates compared to other loans - 401(k) loans come with a low interest rate, sometimes even reaching the famed 0%. The reason for this is that the lender (you) isn't doing this to earn money or, in other words, you're simply using your own resources from your own retirement plan.

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401k loan cons

• Potential income tax penalty - Although 401(k) loans are generally safe as you're making fixed monthly payments to yourself, they aren't without risk. The same rules apply as to any other loan - it needs to be done on time. Failure to do so will cause you to owe income taxes on the outstanding (now defaulted) balance, and you may also receive a penalty to your credit report and score. And, as we all know, a good credit score is crucial when it comes to taking out loans.
  
• Low loan limits - A 401(k) loan might have a low interest rate, but it's also limited in the financial sense. You will only be able to borrow 50% of your total account balance (up to $50,000). For comparison, a personal loan can go up to $100,000 - double the 401(k) maximum amount!
• Lack of compounding returns/interest - This type of financial return goes a long way. What does it mean? Well, it means your returns are generating returns. If you take a 401(k) loan, you're extracting money from your investment pool, eliminating your ability to continue to grow your retirement at the same rate.

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What is a personal loan?

A personal loan is otherwise known as a consumer loan that can be used to pay for a vacation, home renovation, or to consolidate debt. In most cases, these loans are free to be used however you want, with certain exceptions and limits. You can apply for loans by contacting online sellers or going to a bank. Here's how they compare with the 401(k) loan.

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Personal loan pros

• Personal loans are unsecured - Unsecured personal loans do not come with requests for collateral. This means that if your loan defaults, the lender won't be able to seize your assets to pay it off. This gives you some stability and helps you avoid tax penalties. This isn't a license to not repay your debts! Failure to repay your debt obligations to banks and other corporate lenders come with huge financial ramifications.
  
• Fixed, permanent interest rate - Some types of loans have flexible interest rates that change depending on the circumstances. Luckily, personal loans often feature fixed interest rates throughout the loans' duration meaning you will always know exactly how much your monthly payment will be.
  
• Better loan option repayment terms - Personal loans are exceptionally versatile and flexible when it comes to repayment terms. Most banks and online lenders will go out of their way to guarantee you their best terms for loan repayment. This refers to flexibility and duration of loan, not the interest rate (keep reading!).

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Personal loan cons

• Generally high-interest rate - Because there's no collateral involved with personal loans, you may be surprised to see that the interest rate on these loans is higher than expected. Also, you'll need to be careful with your financial goals and any revolving credit because credit scores are pretty important here.
  
• Susceptible to a credit check - A personal loan will most likely require a credit score background check. After all, the lender needs to make sure that you can pay off that loan, with unexpected expenses (such as medical expenses) in mind. A poor credit score means you'll either accrue a high interest rate or get rejected altogether. So, if you have an unpaid loan from before, it would be wise to take care of it and bring your loan balance to zero.
  
• Prepayment penalties and origination fees - Although origination payments are common (where they usually amount to 1% of your loan balance), you can still find loans without them. Also, keep an eye out for penalties for paying the loan off early. Failure to do so may cause you to end up with bad credit due to this unexpected expense.

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Which is the better loan?

The truth is, both loans can be useful in specific situations. Taking money from lenders is good if you know what you're doing and in some cases, a personal loan is a better choice than a 401(k) loan.

So, after after-tax dollars and payroll deductions are done, a personal loan may look better than a 401(k). On the other hand, borrowing money from your retirement savings can ultimately save money since you're paying back the loan to yourself.

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Final Words

Each type of loan is suited for a specific situation and purpose. Both a 401(k) loan and a personal loan can be great choices but it all depends on what you're looking for. Ideally, you would want to contact a couple of credit bureaus for detailed explanations on these loans.

Compare the interest rate, taxable distribution, and whether or not you can achieve early withdrawal before making the choice. Because in the end, your retirement account may or may not be viable enough for a 401(k) loan.

And, as a last piece of advice, pay off your existing and remaining loan balance before taking out another one. Good luck!

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