If you've been working for the same employer for a while, and if your employer offers a defined contribution plan such as a 401(k), the odds are that there's a fair bit of money sitting there, waiting for your retirement. Each pay period, a little money comes out of your check and goes into your 401(k). Typically, you decide how that money's invested, and if you need it before retirement age, you can borrow from it if your plan allows loans. If you then apply for a traditional loan, most lenders will not consider your 401(k) loan as part of your debt-to-income ratio.
When you borrow money from your 401(k), lenders usually do not consider that cash as debt when calculating your debt-to-income ratio.
401(k) Loan Limits
Federal law sets limits regarding how much you can borrow from your 401(k). You can take $50,000 or half the plan's value, whichever is less. For example, if your 401(k) is worth $200,000, you can borrow $50,000 – not $100,000 or 50 percent. You must pay the loan back within five years unless you take the money to purchase your principal residence, and you must pay it off before you begin taking retirement withdrawals. Although you'll pay interest, you effectively pay it to yourself – the interest portion of your loan payments goes back into your plan and add to its value.
Your 401(k) loan isn't technically a debt, so it has no effect on your debt-to-income ratio. Your DTI is the total of all your other debts, divided by your monthly income. It includes your mortgage, home equity loans, car loans, credit card balances, student loans and lines of credit. It does not include typical living expenses, such as utilities, insurance premiums or commuting costs.
As a gauge of your creditworthiness, your DTI works in tandem with other factors, such as your credit score and your income, to form a more complete picture of how likely you are to default if an institution loans you money. Lenders look for DTIs lower than 36 percent. This means that at least 64 percent of your income is left over after paying the debts you already have, so you can devote some of this money to a new loan.
Borrowing from Yourself
Because your 401(k) is your own invested money, a loan taken from it really has no bearing on your debt-to-income ratio. If you don't pay the loan back, no one can sue you to recoup the money. You don't owe anyone but yourself. If you don't pay it back, the unpaid loan is reported to the Internal Revenue Service as a distribution.
You'll have to pay taxes on it, and – depending on your age – you may have to pay a 10 percent tax penalty. This is obviously not something you want to see happen, but lenders generally consider this to be your problem, not theirs. If you're applying for a mortgage or another significant loan, however, you might want to mention your 401(k) loan to avoid problems regarding full disclosure.
Your Credit Report
Your 401(k) loan will not appear on your credit report either. It would be virtually impossible for your plan administrator to report its activity to the credit bureaus, because plan administrators are not set up to do business as lenders. Additionally, your 401(k) is an asset, and assets don't appear on your credit report. What goes on within your 401(k) is your personal business. The flip side to this is that a perfect payment record on the loan won't contribute to your credit score.
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.