What Determines the Interest Rate on a 401k Loan?

Willy Staley

By Willy Staley
Posted on Tue Sep 18, 2012, Last Updated on Wed Sep 10, 2014

Willy Staley is a staff writer and columnist for MyBankTracker.com. His columns cover banking, policy, and culture. More Columns »

What Determines the Interest Rate on a 401k Loan?

Steven Depolo/flickr source

Despite the fact that you are likely not a sovereign nation, you can actually lend money to yourself, believe it or not. It’s true, and it can be much, much cheaper than a credit card — though that doesn’t necessarily make it a good idea. You can take a loan out from your own 401k retirement account, and pay it back to yourself with interest. While it would be nice to give yourself a no-interest loan (especially  considering this is your money), the world just isn’t that fair. 

Whether taking a loan out of your 401k is a good idea or not is a matter for much debate, but it largely depends on your financial situation and your employment stability. The biggest downside to taking such a loan is that, should you lose your job, you are required to pay the loan back in full within 60 days or else risk paying penalties and taxes (once you have defaulted, the loan is treated as an early withdrawal). Furthermore, financial planners will point out that taking principal out of your retirement account will make it grow more slowly, and that’s hard to argue with.

But if your employment situation is stable, you still earn some interest on the money you’ve taken out of your account, although you are the one paying the interest into it.

What is it?

The terms of a 401k loan are set by employers, not by you or the fund administrators, so there is no standard here except for what is legally permissible. You can take out up to 50 percent of your retirement fund (or $50,000, whichever is smaller) as a loan, which can be repaid over a maximum term of five years (with some exceptions) and is typically taken out of payroll (as an after-tax payment, it’s worth noting). And despite what people say, you don’t really pay tax twice on a 401k loan — according to some.

It’s a strange and complex financial product. Some have even pointed out that it is, technically speaking, a means of diversifying your investments — even if you’re the source of the interest payments. And for an emergency loan (or a loan for someone with damaged or no credit), a 401k loan can have attractive interest rates.

What determines the interest rate?

Typically, according to most sources, a 401k loan will carry an interest rate based on the Prime Rate plus 1 or 2 percentage points. The prime rate is published every day by the Wall Street Journal, based on surveys of 30 banks’ lending rates. Currently it’s at 3.25% and hasn’t budged for a year. So, a 60-month 401k loan might only have an APR of 5.25%.

That’s about half the national average interest rate for low-interest credit cards (10.4%) and less than a quarter the rate for bad credit credit cards (23.64%), according to data from CreditCards.com. Its low rates are comparable only to a HELOC, which, if you don’t have any home equity to tap into, you can’t get. And unlike with HELOC, you’re actually paying yourself the interest — not your bank.

 

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  • Jstew

    So glad to find an article written by an author that can understand there is no “double taxation” on the principle. However the interest portion is taxed twice- although minimal especially when the length of the loan is shortened. The 401k loan can be a great asset in your financial arsenal when used correctly.