Do Retirement Account Loans affect your credit score?
In today's uncertain economic climate, it's becoming increasingly common for people to turn to their retirement accounts as a way to access cash in times of need. But what many people don't realize is that taking a loan against your 401(k) or other retirement account can have a significant impact on your credit score.
So, the question is: do retirement account loans affect your credit score? The answer, as with so many financial matters, is not a simple one.
Let's start by discussing what a retirement account loan is. Essentially, it's a loan that you take out against the balance of your retirement account (usually a 401(k) or IRA). The loan is generally repaid through automatic payroll deductions over a period of several years.
On the surface, retirement account loans may seem like an attractive option. You're essentially borrowing money from yourself, which means there's no credit check, no loan application, and no interest expense to a lender. Plus, the interest you pay on the loan is paid back into your own retirement account, so you're essentially paying interest to yourself.
However, there are several downsides to taking out a retirement account loan. First, the loan amount is usually limited to a percentage of your account balance (typically 50% or less), which means you may not be able to access as much cash as you need. Second, if you're unable to repay the loan for any reason (say, you lose your job), the outstanding balance may be treated as a distribution from your retirement account, which is subject to taxes and penalties.
But let's get back to the original question: do retirement account loans affect your credit score? The answer is yes, but only indirectly.
When you take out a retirement account loan, it doesn't show up on your credit report. That's because you're not borrowing money from a lender, so there's no credit check involved. However, if you're unable to repay the loan and default, the loan will be considered a distribution from your retirement account. That can have a significant impact on your credit score.
The reason for this is twofold. First, a retirement account distribution will generally be considered taxable income, which means you'll owe taxes on the amount you borrowed. Depending on the amount of the loan and your income level, this could have a significant impact on your tax liability.
Second, if you're under age 59 1/2, the distribution will also be subject to a 10% early withdrawal penalty. This penalty applies regardless of whether the distribution was voluntary (like a retirement account loan) or involuntary (like a layoff or medical emergency). So, if you take out a retirement account loan and are unable to repay it, you could be hit with a double whammy of taxes and penalties.
But that's not all. Even if you are able to repay the loan and avoid default, taking out a retirement account loan can still have an indirect impact on your credit score. That's because when you take out a loan, you're reducing the amount of money that's invested in your retirement account. Over time, that can result in lower returns and a smaller retirement nest egg. If you're unable to make up the difference through additional contributions, you may find yourself short on funds when it's time to retire.
So, should you ever take out a retirement account loan? As with so many financial decisions, the answer depends on your specific situation. If you're facing a financial emergency and have exhausted all other options, a retirement account loan may be your best bet. But if you're simply looking for a way to access cash for a major purchase or expense, it's generally best to explore other options first.
Some alternatives to consider include:
- A personal loan from a bank or credit union
- A home equity loan or line of credit
- A low-interest credit card
- A loan from family or friends
In conclusion, while retirement account loans can be a tempting option for accessing cash, they do have the potential to negatively impact your credit score. From taxes and penalties to reduced returns and a smaller retirement nest egg, there are several factors to consider before taking out a loan. Before making any financial decision, it's always a good idea to consult with a financial advisor or other qualified professional.