3 times a 401(k) loan makes sense — and what to know before you take one out

Tapping into your 401(k) before retirement can decrease what you'll have available in your golden years — and it usually comes with a penalty.

But there are some situations where borrowing from your 401(k) plan is your best option.

In 2023, the number of Americans who took out a 401(k) loan went up by 14%, according to an annual report from retirement fund administrator Empower. The company cited increased credit card debt, higher interest rates and the resumption of student loan payments as leading factors for the increase.

The same report found that 27% of respondents were "very or somewhat likely" to take out a loan or hardship withdrawal from their retirement plan in the next six months.

Below, find out how a 401(k) loan works, when it's the right call and how to minimize the impact on your nest egg.

A 401(k) loan allows you to borrow from your workplace retirement fund. It doesn't require a credit check and you're not hit with the taxes and penalties you'd face with a hardship withdrawal.

While you do pay interest on the money you borrow, that interest is funneled back into your retirement account.

There's a limit on how much you can borrow --- usually $50,000 or 50% of your vested account balance, whichever is smaller, over 12 months. In most cases, you must make payments at least quarterly and repay the entire loan within five years. And if you leave your employer, the money is usually due in full.

A 401(k) loan should be your last resort, according to Rob Williams, managing director of financial planning and wealth management at Charles Schwab.

"It's an emergency resource, so make sure there are no other viable options," Williams said. "It's not the best to borrow against a 401(k) for something opportunistic," like a vacation.

Even in an emergency, you should consider a personal loan before a 401(k) loan. CNBC Select recommends LightStream Personal Loans as the best overall and Discover Personal Loans as the best for next-day funding.

There are situations where borrowing from your 401(k) is the best — or only — choice. If you think you fall into one of these categories, your first step should be to talk to your employer to see if they offer 401(k) loans.

"Each employer has different rules, different provisions, different interest rates and limits," Williams said. 

You have no other viable options

A 401(k) loan may make sense if you've explored all other avenues or if the alternative is high-interest credit card debt.

"All else being equal, a credit card is going to be a lot more expensive," Williams said. "And there's less forced discipline involved in paying it back."

Interest on a 401(k) loan is typically the prime rate plus a point or two, significantly lower than those offered by traditional credit cards.

Information about 401(k) loans isn't reported to the credit bureaus so, unlike credit card debt, it won't affect your debt-to-income ratio and late payments won't hurt your credit score.

You have medical expenses

Medical emergencies can derail even the most budget-conscious person: About one in five adults with medical debt owe $5,000 or more, according to the Urban Institute.

Borrowing from your 401(k) could be a valid solution if you have medical expenses that your health insurance doesn't cover. If you have access to a health savings account through your job, however, use those funds first.

You need a down payment on a home

You don't always need to make a 20% down payment to buy a home. But if you want to avoid paying mortgage insurance, it's still going to be a significant sum. A 401(k) loan could help you get the funds to land your dream home.

While most 401(k) loans must be repaid within five years, you can usually negotiate a much longer term if you use one to buy a house, according to Williams — up to 30 years, depending on your plan.

Before applying for a 401(k) loan, consider these benefits and drawbacks.

Pros of a 401(k) loan

• No credit check or application. It can be much easier and faster to get approved for a 401(k) loan.
• Payments are automated. Most employers will set up automatic payroll deductions
• You pay interest to yourself. 401(k) loans have much lower interest rates than personal loans and credit cards. And any interest you do generate goes back into your plan.

Cons of a 401(k) loan

• The money isn't growing. The funds you've borrowed aren't being invested, and don't have a chance to benefit from compound interest.
• Your loan is tied to your job. If you leave, whether it's your choice or not, you'll need to repay that loan quickly. 
• You may not be able to keep contributing. Depending on your plan, you might not be able to make contributions to your 401(k) while you're repaying the loan.

A 401(k) loan should only be considered as a last resort. If you have to borrow from your retirement account, continue to make contributions if you can and be sure to pay it back in full. 

At CNBC Select, we work with experts who have specialized knowledge and authority based on relevant training and/or experience. For this story, we interviewed Rob Williams, a certified financial planner and managing director of financial planning and wealth management at Charles Schwab.

At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed decisions with their money. Every investing review is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of investing products. While CNBC Select earns a commission from affiliate partners on many offers and links, we create all our content without input from our commercial team or any outside third parties, and we pride ourselves on our journalistic standards and ethics.

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