Borrowing money has the potential to impact your credit score in different ways. First, the simple act of applying for a loan or credit card will generally result in a hard inquiry on your credit report. And that right there could cause a minor credit score drop — usually in the vicinity of five points.
What’s more, if you rack up a balance on a credit card but fall behind on your payments, or you take out a personal loan and default, your credit score could sustain serious damage.
But 401(k) loans work a bit differently. One big benefit of taking out a 401(k) loan is that you’re repaying yourself instead of letting a lender or credit card company make money by charging you interest. Also, because you’re borrowing against your personal retirement savings, you don’t need to undergo a credit check to qualify.
Not every 401(k) plan allows for loans. But if yours does, you can take out that loan without having a hard inquiry done on your credit. That could prevent your score from taking a minor hit.
Even more importantly — from a credit score perspective, at least — if you fall behind on your 401(k) loan payments, your credit score won’t take a dive. Missed 401(k) loan payments aren’t reported to the credit bureaus the same way missed loan or credit card payments are.
But while taking out a 401(k) loan might seem like your best bet from a credit score standpoint, there are still big risks in going this route. It’s best to proceed with caution if you’re thinking of borrowing against your 401(k).
You could risk a serious penalty
Failing to repay your 401(k) loan may not hurt your credit. But it could still hurt you financially in a really big way.
If you don’t repay your 401(k) loan on time, that unpaid sum will count as a full-fledged 401(k) withdrawal. If you’re not yet 59 1/2 years old, that withdrawal will then trigger a 10% early withdrawal penalty. Plus, you’ll be taxed on your withdrawal.
To be clear, with a traditional 401(k) plan, you’re always taxed on withdrawals. But it’s something to keep in mind nonetheless.
Let’s say you borrow $10,000 from your 401(k). If you don’t pay that sum back at all, you’ll lose $1,000 off the bat to the aforementioned penalty. But you’ll also pay taxes on the entire $10,000 sum. So let’s say you’re in the 22% tax bracket. You might also lose $2,200 of that $10,000 to taxes.
And if you’re thinking, “Well, then, I’ll make a point not to default on my 401(k) loan,” consider this: If you end up leaving your job — whether voluntarily or because you’re laid off — your repayment window for that loan might be whittled down to just a few months.
Your specific 401(k) plan should spell out the rules of what happens in that scenario. But you might end up with a lot less time to repay your 401(k) loan than expected.
You could also leave yourself short for retirement
Another problem with taking out a 401(k) loan? If you don’t repay that money, in addition to penalties and taxes, you’ll risk having a lot less money for your senior years.
Over the past 50 years, the stock market’s average annual return has been 10%. A $10,000 loan you take from your 401(k) that you don’t repay could cost you over $174,000 in retirement income if you remove that sum 30 years ahead of your workforce exit and the investments in your 401(k) normally deliver that same 10% average annual return. (Or, to put it another way, 30 years of missed growth on a $10,000 sum could leave you with $174,000 less.)
As such, be very careful when borrowing against your 401(k). Doing so may not hurt your credit — even if you default on your loan. But there could still be severe consequences you’re left to deal with.
