How does a 401(k) loan work — and is it a good idea?

When you borrow money from your 401(k), you're essentially your own lender. The loan terms are attractive. There's no credit check. You get a low interest rate — which you pay to yourself — and repay the loan within five years. And unlike with 401(k) withdrawals, you won't be subject to additional income taxes and early withdrawal penalties.

All this makes 401(k) loans appear like a viable option when you're experiencing a financial emergency or looking to fund an important goal. However, it's wise to learn about the risks before you apply. CNBC Select explains how you can take out a loan from your retirement account and what you should keep in mind before taking this step.

• How to take out a loan from your 401(k)
• What to consider before borrowing from your 401(k)
• Alternatives to a 401(k) loan
• Bottom line

With a 401(k) loan, you can borrow money from your workplace retirement account and pay it back with interest. Both the balance payments and interest go back into your 401(k) account. The rate can fluctuate and is typically one or two points higher than the prime rate. For example, if the prime rate is 7%, you can expect to pay an 8% or 9% interest rate on your 401(k) loan.

To take out a loan, you'll first need to check if your plan even allows it. If so, you can request a loan from your plan administrator. According to Fidelity, you can borrow as much as 50% of your retirement savings, up to a $50,000 maximum. The specific terms depend on your plan's rules. If your request is approved, you'll receive money from investments in the account that are sold to cover the loan amount.

In most cases, you'll have five years to pay back the loan, provided you stay with the employer who sponsors the 401(k). If you leave your job before repaying the full balance, you'll likely have a very short period to finish repayment.

Consider the following pros and cons when deciding whether borrowing from your retirement account is the right choice.

Advantages of 401(k) loans

• No credit checks. A low credit score won't result in a rejected application. Moreover, a 401(k) loan won't affect your credit at all — even if you default on it.
• Low interest rates. You'll pay a modest interest rate and this money goes straight into your retirement account.
• No taxes or fees (if you pay it back). With a loan, you won't have to pay taxes or penalty fees like you will if you withdraw the money.

Risks of 401(k) loans

• Taxes and fees (if you default). If you fail to repay your 401(k) loan as agreed and you're under 59½, you'll owe taxes and a 10% penalty.
• A loan tied to your employer. Because a 401(k) is an employer-sponsored account, things get complicated if you leave (or are asked to leave) your job — you'll have to repay the full amount of your loan before the due date of your federal income tax return.
• Derailing your retirement savings. Your retirement savings are crucial to your financial stability in the future. If you take out a loan against them, you'll probably miss out on their potential growth — which could total to more than the amount you'd repay yourself in interest.

A 401(k) loan might be worth considering if you have a massive emergency expense but don't have enough in savings. It's also an option for debt consolidation if you have high-interest credit card debt. Still, it's wise to explore alternatives before you borrow against such a vital asset as your retirement funds.

Get a 0% APR credit card

If your credit is in good shape, you could qualify for a 0% APR credit card. This type of card allows you to avoid interest charges on new purchases for a specified period. The best 0% APR cards can give you longer than a year with no interest. For example, the Wells Fargo Reflect® Card offers 0% intro APR for 21 months from account opening on purchases and qualifying balance transfers (17.49%, 23.99%, or 28.24% variable APR thereafter; balance transfers made within 120 days qualify for the intro rate, BT fee of 5%, min: $5). Or look into a rewards credit card such as the Capital One Savor Cash Rewards Credit Card which comes with a 0% intro APR on purchases and balance transfers for 12 months (18.49% - 28.49% variable APR thereafter).

Remember that while a 0% APR card can be excellent for interest savings, you only want to use it if you have a solid plan to repay the balance before the zero-interest period expires. Otherwise, you'll be hit with expensive interest charges.

Take out a personal loan

If you need to borrow a large sum that will take a couple of years to pay off, a traditional personal loan can be helpful. You'll have a consistent monthly payment over several years, as well as a fixed interest rate. You'll likely pay more interest to a lender than you would yourself with a 401(k) loan — but you'll also avoid the risks that come with taking money from your retirement account.

Plus, it's possible to get a personal loan even with bad credit. CNBC Select recommends OneMain Financial which offers flexible terms and loan amounts. Avant is also a great choice if you need quick funding — borrowers can receive the money as soon as the next day after applying.

In a financial crunch, a 401(k) can make sense, allowing you to avoid riskier financing sources such as payday lenders. At the same time, be careful pulling money from such an important investment vehicle. If you can obtain cash without putting your assets at risk, you might want to do just that.

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 loan guide is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of loan 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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