Does Borrowing From Your 401(k) Hurt Your Credit?

With a traditional loan, each lender you approach pulls your credit report, which results in an inquiry on your credit report. Then, after you take out the loan, it shows up as debt, which can lower your credit score. When you take out a 401(k) loan, you're borrowing your own money, so there's no lender to pull your credit score. When the plan disburses the loan funds to you, it doesn't show up on your credit report, so it won't add to your debt. Plus, it isn't considered long-term debt, so it doesn't hurt your chances of being approved for a mortgage.

Because the loan isn't reported on your credit score, paying it on time according to the loan terms doesn't improve your credit score. When you have a loan that is reported to the credit bureaus, each on-time payment builds your payment history, which bolsters your credit score.

Don't read the lack of impact on your credit score to say that default on your 401(k) loan doesn't have negative consequences. If you don't pay your loan back, the amount of the loan counts as taxable income in the year you default. Worse, when you're under 59 1/2 years old, it counts as an early withdrawal, which means the Internal Revenue Service tacks on a 10 percent penalty. For example, if you're in the 15-percent tax bracket, between the tax and penalty, that's 25 percent of the loan amount you now owe the government.

When you take a loan from your 401(k) plan, you pay interest on the amount borrowed. However, that interest goes back into your account. While that might sound like a pretty sweet deal, keep in mind that while the loan is outstanding, that money isn't being invested in the 401(k) plan, so you're missing out on investment returns. For example, if you're paying 4 percent interest but your 401(k) plan investments returned 7.5 percent, you're missing out on 3.5 percent growth.