SoFi

A 401(k) loan allows you to borrow money from your retirement savings and pay it back to yourself over time, with interest. While this type of loan can provide quick access to cash at a relatively low cost, it comes with some downsides.

Read on to learn about borrowing against a 401(k), how 401(k) loans work, when it may be appropriate to borrow from your 401(k) — and when you might want to consider an alternative source of funding.

Can I Borrow From My 401(k)?

Borrowing from a 401(k) is possible under many 401(k) plans. In general, it’s wise to let your retirement savings stay invested so you’ll have that money for the future, but in some circumstances, borrowing against a 401(k) could make sense. For instance, if you find yourself in a situation where you need money immediately and have no other options, you may want to consider a 401(k) loan.

A 401(k) loan lets you borrow money from your retirement savings account and pay it back over time with interest. You’re essentially paying back yourself — the money you borrow against your 401(k) goes back into your 401(k) account with interest.

Not all 401(k) plans offer loans, so check with your plan administrator to find out if yours does.

What Is a 401(k) Loan & How Does It Work?

A 401(k) loan is a provision that allows participants in a 401(k) plan to borrow money from their own retirement savings. Here are some key points to understand about 401(k) loans.

Limits on How Much You Can Borrow

The Internal Revenue Service (IRS) sets limits on the maximum amount that can be borrowed from a 401(k) plan. Typically, you can borrow up to 50% of your account balance or $50,000, whichever is less, within a 12-month period.

Spousal Permission

Some plans may require borrowers to get the signed consent of their spouse before a 401(k) loan can be approved.

You Repay the Loan With Interest

Unlike a withdrawal, a 401(k) loan requires repayment. You typically repay the loan (plus interest) via regular payroll deductions, over a specified period, usually five years. These payments go into your own 401(k) account.

401(k) Loans vs. Early Withdrawals

When you withdraw money from your 401(k), these distributions generally count as taxable income. And, if you’re under the age of 59½, you typically also have to pay a 10% penalty on the amount withdrawn.

You may be able to avoid a withdrawal penalty, if you have a heavy and immediate financial need, such as:

•  Medical care expenses for you, your spouse, or children

•  Costs directly related to the purchase of your principal residence (excluding mortgage payments).

•  College tuition and related educational fees for the next 12 months for you, your spouse, or children.

•  Payments necessary to prevent eviction from your home or foreclosure

•  Funeral expenses

•  Certain expenses to repair damage to your principal residence

While the above scenarios can help you avoid a penalty, income taxes will still be due on the withdrawal. Also keep in mind that an early withdrawal involves permanently taking funds out of your retirement account, depleting your nest egg.

With a 401(k) loan, on the other hand, you borrow money from your retirement account and are obligated to repay it over a specified period. The loan, plus interest, is returned to your 401(k) account. But during the term of the loan the money you borrow won’t enjoy any potential growth.

Recommended: Can I Use My 401(k) to Buy a House?

Should You Borrow from Your 401(k)?

It depends. In some cases, borrowing against a 401(k) can make sense, while in others, it may not. Here’s a closer look.

When to Consider a 401(k) Loan

•   You’re in an emergency situation. If you’re facing a genuine financial emergency, such as medical expenses or imminent foreclosure, a 401(k) loan may provide a timely solution. It can help you address immediate needs without relying on more expensive forms of borrowing.

•   You have expensive debt. If you have high-interest credit card debt, borrowing from your 401(k) at a lower interest rate can potentially save you money and help you pay off your debt more efficiently.

When to Avoid a 401(k) Loan

•   You want to preserve your long-term financial health. Depending on the plan, you may not be able to contribute to your 401(k) for the duration of your loan. This can take away from your future financial security (you may also miss out on employer matches). In addition, money removed from your 401(k) will not be able to potentially grow or benefit from the effects of compound returns.

•   You may change jobs in the next several years. If you anticipate leaving your current employer in the near future, taking a 401(k) loan can have adverse consequences. Unpaid loan balances may become due upon separation, leading to potential tax implications and penalties.

Pros and Cons of Borrowing From Your 401(k)

Given the potential long-term cost of borrowing money from a bank — or taking out a high-interest payday loan or credit card advance — borrowing from your 401(k) can offer some real advantages. Just be sure to weigh the pros against the cons.

Pros

•   Efficiency: You can often obtain the funds you need more quickly when you borrow from your 401(k) versus other types of loans.

•   No credit check: There is no credit check or other underwriting process to qualify you as a borrower because you’re withdrawing your own money. Also, the loan is not listed on your credit report, so your credit won’t take a hit if you default.

•   Low fees: Typically, the cost to borrow money from your 401(k) is limited to a small loan origination fee. There are no early repayment penalties if you pay off the loan early.

•   You pay interest to yourself: With a 401(k) loan, you repay yourself, so interest is not lost to a lender.

Cons

•   Borrowing limits: Generally, you are only able to borrow up to 50% of your vested account balance or $50,000 — whichever is less.

•   Loss of potential growth: When you borrow from your 401(k), you specify the investment account(s) from which you want to borrow money, and those investments are liquidated for the duration of the loan. Therefore, you lose any positive earnings that would have been produced by those investments for the duration of the loan.

•   Default penalties: If you don’t or can’t repay the money you borrowed on time, the remaining balance would be treated as a 401(k) disbursement under IRS rules. This means you’ll owe taxes on the balance. And if you’re younger than 59 ½, you will likely also have to pay a 10% penalty.

•   Leaving your job: If you leave your current job, you may have to repay your loan in full in a very short time frame. If you’re unable to do that, you will face the default penalties outlined above.

Alternatives to Borrowing From Your 401(k)

Because borrowing from your 401(k) comes with some drawbacks, here’s a look at some other ways to access cash for a large or emergency expense.

Emergency fund: Establishing and maintaining an emergency fund (ideally, with at least three to six months’ worth of living expenses) can provide a financial safety net for unexpected expenses. Having a dedicated fund can reduce the need to tap into your retirement savings.

Home equity loans or lines of credit: If you own a home, leveraging the equity through a home equity loan or line of credit can provide a cost-effective method of accessing extra cash. Just keep in mind that these loans are secured by your home — should you run into trouble repaying the loan, you could potentially lose your house.

Negotiating with creditors: In cases of financial hardship, it can be worth reaching out to your creditors and explaining your situation. They might be willing to reduce your interest rates, offer a payment plan, or find another way to make your debt more manageable.

Personal Loans: Personal loans are available from online lenders, local banks, and credit unions and can be used for virtually any purpose. These loans are typically unsecured (meaning no collateral is required) and come with fixed interest rates and set terms. Depending on your lender, you may be able to get funding within a day or so.

The Takeaway

Borrowing against your 401(k) can provide short-term financial relief but there are some downsides to consider, such as borrowing limits, potential loss of growth, and penalties for defaulting.

It’s a good idea to carefully weigh the pros and cons before you take out a 401(k) loan. You may also want to consider alternatives, such as using non-retirement savings like an emergency fund or taking out a personal loan or a home equity loan or line of credit.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.

FAQ

What is a 401(k) loan?

A 401(k) loan allows you to borrow money up to a certain amount from your retirement savings account and pay it back over time with interest. The money you repay goes back into your 401(k) account.

How do 401(k) loans work?

A 401(k) loan allows you to borrow money from your 401(k) account. Not every plan allows 401(k) loans, but many do. There are limits on how much you can borrow — generally up to 50% of your account balance or $50,000, whichever is less, within a 12-month period. In addition, you may have to get your spouse’s permission to take out a 401(k) loan, and you need to repay the amount you borrowed with interest typically within five years.

When should I consider taking a 401(k) loan?

It’s generally best not to touch money in a retirement savings account if possible so it can potentially keep growing for your future. However, in some situations it may make sense to take out a 401(k) loan — for instance, if you’re facing an immediate medical emergency or you’re trying to pay off extensive high-interest debt, such as credit card debt. If you have no other financial options, a 401(k) loan might be something to consider.

How do 401(k) loans differ from early 401(k) withdrawals?

With a 401(k) loan, you borrow money from your retirement account and must repay it over a specified period, typically within five years. The loan, plus interest, is repaid to your 401(k) account. An early 401(k) withdrawal, on the other hand, is when you withdraw money from your 401(k) before age 59½. These distributions generally count as taxable income. And because you’re under the age the IRS specifies for qualified retirement withdrawals, you typically will also have to pay a 10% penalty on the amount you took out.

There are some possible exceptions to the early withdrawal penalty. If you have a heavy and immediate financial need, such as medical expenses, for example, you may be able to avoid the 10% penalty on an early 401(k) withdrawal.

What are some alternatives to borrowing from my 401(k)?

Alternatives to borrowing from your 401(k) include taking the money from an emergency savings fund, taking out a home equity loan if you have equity in your house, taking out a personal loan, or negotiating with your creditors to see if they might be willing to put you on a payment plan.

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

SOPL-Q225-001

Asian options (also known as average strike options or average options) are a type of exotic option whose price is based on an asset’s average price over time rather than its spot price at expiration. In average strike options, the strike price is based on the average price of the underlying asset over a set period, rather than being fixed at the outset.

Asian options can help mitigate price volatility, making them useful for businesses managing currency or commodity risks. Lower price volatility also means they tend to be less expensive than standard options.

What Is an Asian Option?

Asian options are a type of exotic option that trades differently than standard American or European options.

American and European options allow holders to exercise an option at a predetermined strike price. The key difference between them is timing: American options can be exercised anytime before expiration, while European options are only exercised on the expiration date.

Asian options, on the other hand, are priced based on the average price of the asset over a period of time, and like European options, they are exercised only on the expiration date.

The specific terms of an Asian option, such as the averaging period and method, are negotiable. There are two different types of Asian options: average strike options and average price options.

Average strike options are issued with an unknown strike price, which is determined based on the average price of the underlying asset at selected time intervals.

Average price options, conversely, are issued with a known strike price, but an unkown payoff. With these, the payoff is determined at expiration, based on the average price of the underlying asset over a period of time. Both types of Asian options may be priced according to arithmetic or geometric averages.

Who Buys Asian Options?

Asian options are commonly used by businesses that deal with price-sensitive goods or currencies. These options buyers are often in sectors like energy, agriculture, and international trade — areas where prices can swing sharply due to market volatility or seasonal fluctuations.

Because Asian options can help smooth out short-term price spikes, they can help protect against rate manipulation, inefficient pricing in thinly traded markets, or sudden shifts in currency exchange rates.

How Asian Options Work

Like standard options, the price of a call or put in Asian options depends on the price of the underlying asset at expiration. Unlike standard options, the price of an Asian option is determined by the average price of the underlying asset over a specified period, rather than the spot price at expiration.

The way the average price is calculated in an Asian option, such as the averaging method and time intervals, is defined by the contract. It’s common for Asian options to define average either as an arithmetic or geometric mean over a period of time (e.g., 30 days), which impacts pricing.

Maximum Payoff

Like standard options, the potential payoff for an Asian option depends on whether a trader is buying a call or a put option. Even though the prices of Asian options are determined by the average price instead of the spot price, the payoff structure for Asian options works in the same way.

For a call option buyer, the maximum payoff is theoretically unlimited, since there is no limit on how high the stock’s price can go. However, in practice, the payoff is usually constrained by the average price calculation over the option’s life.

For a put option buyer, the maximum payoff can be seen if the stock’s price declines significantly (or even goes to zero), though losses are generally capped at the initial investment.

Maximum Loss

Losses for buyers of Asian options are generally limited to the premiums paid at the initiation of the trade, making them a defined-risk strategy. Because of the average effect that reduces volatility, purchase premiums are often lower than those for standard options.

Breakeven

The breakeven price of an Asian option depends on the strike price of the option and the premium initially paid for the option. If a buyer paid $1.50 for a call option with a strike price of $50, the breakeven price would be $51.50 (the strike price of $50 plus the $1.50 in premium paid originally).

If the stock’s average price when the option expires is above $51.50, the investor could earn a profit on the option investment.

The breakeven point for an average strike option is less predictable than for standard options, as it is not known until expiration. But it follows the same principle, as it is determined by the final strike price and the premium paid.

Pros and Cons of Asian Options

Here are some of the pros and cons of trading with Asian options:

Asian Option Pricing

Because Asian options are priced based on an average price instead of the spot price at expiration, they experience relatively lower volatility and are generally less expensive than standard options. This is because averaging several price values over time may dampen out extreme values. Because volatility is a key measure of the price of an option, the lower volatility of Asian options generally means lower prices as well.

How Asian Option Pricing Works

The pricing of Asian options is calculated using an average value, which can be determined through either an arithmetic or geometric mean. In practice, pricing the value of Asian options can be complex, requiring advanced calculations, but the following examples illustrate how these options work.

Asian Options Pricing Example – Average Price Option

Assume that an investor buys a 90-day call option with a strike price of $50. This option costs $1.25, and the average price is defined as the arithmetic mean of the underlying asset price taken every 30 days.

The stock has a price of $51.00, $48.50, and $52.00 at the 30, 60, and 90-day mark. The arithmetic mean of those three prices is ($51 + $48.50 + $52) / 3, or $50.50. Since the option has a strike price of $50, the option closes with a value of $0.50 (the calculated price at expiration minus the strike price, $50.50 – $50).

Because the investor purchased the option for $1.25, in this scenario, they would take a loss of $0.75 per share. Since one options contract typically covers 100 shares, this would result in a total loss of $75.

If the arithmetic mean were $53.00, the option would be worth $3.00 at expiration. After subtracting the $1.25 premium paid, the investor would gain $1.75 per share, ) or $175 total on a standard contract. As with standard options, if the average price of the underlying asset is below the strike price (for a call option), the option expires worthless.

Asian Options Pricing Example – Average Strike Price Option

An investor buys a 90-day call option for a stock. This option costs $1.25, and the average strike price is defined as the arithmetic mean of the underlying asset price taken every 30 days.

The stock has a price of $51.00, $48.50, and $52.00 at the 30, 60, and 90-day mark. The arithmetic mean of those three prices is ($51 + $48.50 + $52) / 3, or $50.50. Therefore, at expiration the strike price will be $50.50. The option closes with a value of $1.50 per share ($52.00 – $50.50).

Because the investor originally purchased the option for $1.25, in this scenario, they would have a gain of $0.25 per share. The value of the option at expiration is $1.50, and after subtracting the $1.25 premium paid, the net gain is $0.25 per share. Since one options contract typically covers 100 shares, this would result in a total profit of $25.

The Takeaway

Unlike standard options, which are valued based on the spot price of the underlying asset at expiration, Asian options are valued based on the average price of the underlying asset over a specified period before expiration.

Because the value of an Asian option is derived from an average of prices, it generally experiences less price volatility. Lower volatility generally leads to cheaper prices than standard options.

SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.

With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.

FAQ

Are Asian options cheaper?

Asian options are often (but not always) cheaper than standard American or European options due to their lower volatility, which results from using an average price rather than the spot price at expiration. Because an average price is used, Asian options are generally less volatile, and typically cheaper as a result.

How are Asian options priced?

Rather than using the spot price at expiration, Asian options are priced using an average value, typically calculated using an arithmetic or geometric mean over time.

Why can’t Black-Scholes models value Asian options?

The Black-Scholes pricing model is one of the most common ways to price standard American or European options. To price options, the Black-Scholes method makes a variety of assumptions about the price of the underlying stock. One assumption in the Black-Scholes model is that the stock’s price will move according to Brownian motion. Because arithmetically averaged Asian options do not follow the assumption of Brownian Motion, the standard Black-Scholes pricing model does not apply.

Photo credit: iStock/Boris Jovanovic