Using A 401(k) Loan To Buy A Car: Is It Smart?

You can use a 401(k) loan to buy a car, but there may be financial consequences, including fees and tax penalties. Taking a loan from a retirement fund can also impact your retirement readiness if it is not managed and repaid responsibly. Before you head to the dealership, carefully consider whether you should borrow from your 401(k) or use a traditional auto loan to buy a car.

How a 401(k) loan works

A 401(k) loan involves borrowing money from your retirement savings and repaying yourself over time. While the funds do go back into your retirement account, you may lose out on earning interest — and any unpaid amount could be subject to tax penalties.

To get started, you will likely be required to complete an application provided by the plan administrator. The IRS requires that most 401(k) loans be repaid within five years and that payments be made at least on a quarterly basis. Some plans, however, require more frequent payments and may even allow those payments to be automatically deducted from your paycheck.

Loan repayments will include interest, which is typically a point or two higher than the current prime interest rate. The current prime rate as of November 2024 is 8.0 percent — which means your interest rate could range from 9.0 percent to 10.0 percent. The interest payments will be deposited into your retirement account like the principal payments.

Unlike traditional auto loans, 401(k) loan rates aren’t based on your credit score. As a result, if you have poor credit, you might be able to get a lower rate than you would with a bad credit auto loan.

Restrictions on 401(k) loans

Not all employer-sponsored 401(k) plans allow program participants to take loans. Check with your plan administrator to find out whether a 401(k) loan for cars is an option that’s available to you.

For retirement savings programs that do allow loans, there are IRS restrictions regarding how much money can be borrowed. The IRS limits 401(k) loans to 50 percent of your vested account balance or $50,000, whichever is less. However, the IRS rules include an exception to the 50 percent limit — you can always borrow up to $10,000.

When you request a loan from a 401(k) plan, your employer should provide you with information about the borrowing limit restrictions and any other guidelines. These should include the minimum account balance required for the loan and the number of loans permitted by the plan.

How to decide if a 401(k) loan is right for you

Sometimes, a 401(k) loan is the most cost-effective way to purchase a car. Before you borrow, make sure the vehicle you want is in your budget, that you’re still getting a good return on your interest and that there aren’t other, less risky options available to you.

Is the car in your budget?

Consider the type of car you want. How much will this cost? What is the upfront cost, and what will the recurring loan payment and interest be? It’s possible the car that you want doesn’t make sense for your budget.

If you need a car, try to find an option that balances that necessity without depleting your investments. Figure out how much car you can afford first and determine if that will meet your needs.

Is this the best rate you can get?

Because of your credit score or other circumstances, you may not be able to get a competitive interest rate on a traditional auto loan. The interest rate available through your 401(k) fund may be more favorable.

Make sure to compare rates among banks, credit unions and online lenders to see what rates you qualify for before committing to a 401(k) loan. If you cannot get a more reasonable interest rate elsewhere, a 401(k) loan may be the right choice.

Is your job stable?

Using a 401(k) loan to buy a car makes more sense for individuals who do not plan to leave their current employer anytime soon. These folks would not face the possibility of repaying the outstanding balance of a 401(k) loan in full.

If you do end up leaving your job, the loan from your 401(k) or other retirement plan may be treated as a distribution and subject to tax penalties, so think through your future employment plans and goals carefully before taking a loan.

Will your retirement funds suffer?

Whenever money is withdrawn from a retirement fund, you lose out on the potential growth you could have realized with the money still invested. That growth could easily amount to more than the interest you’ll be paying yourself as part of the loan repayment process.

Review this trade-off carefully. Use a 401(k) calculator to crunch the numbers, and consider talking with a financial professional who can help.

Drawbacks to using a 401(k) loan to buy a car

Before going ahead with a 401(k) loan, consider the potential drawbacks carefully as they can be costly and have long-term impacts.

• Limited withdrawals: You are limited to either $50,000 or 50 percent of the funds in your 401(k), whichever is less. Since new vehicles cost close to $50,000 on average — according to data from Kelley Blue Book — your purchasing power will be limited compared to a traditional auto loan.
• Fees: There may be fees associated with a 401(k) loan, including origination fees of $50 to $100 and maintenance fees ranging from $25 to $50.
• Leaving the company: If you leave your employer before the 401(k) loan has been fully repaid, you may be required to pay the loan’s outstanding balance in full. If you cannot repay the balance when leaving an employer, the employer can treat the loan as a distribution, which will have tax consequences.
• Repayment timeline: There is a five-year loan term for 401(k) loans. If you fail to repay your loan within that time, the IRS will view the loan as a distribution and impose income tax on the money borrowed and a 10 percent early withdrawal fee — unless you qualify for a penalty-fee withdrawal.
• Less potential growth: By dipping into your 401(k), you’ll be shrinking the principal investment, which means you’ll have less money earning interest. This may limit your long-term growth potential, although the interest you pay on your loan does still go back into your retirement account.

Bottom line

When considering your car financing options, remember to balance the cost against other benefits, like avoiding a hard pull on your credit. By avoiding common 401(k) mistakes, you can better protect your earnings while getting the money you need to purchase a vehicle.

If you do opt to borrow from a 401(k) or retirement plan to buy a car, make sure the auto loan interest rate you will pay for the loan is the same or lower than the interest rate you might get elsewhere. Also, make sure you understand the tax ramifications of taking a loan from your retirement account. If you have questions about any of these issues, consider talking with a financial advisor who can help you decide whether a 401(k) loan is the best option.