What Interest Rate Do 401(k) Loans Charge and Who Receives It?
Every loan has an interest rate, but the question of where that interest actually goes is more interesting than usual when the lender and the borrower are, functionally, the same person.
The short answer
Most 401(k) plans set loan interest using a common method: a benchmark rate, often the prime rate, plus a small margin, such as one percentage point. Unlike a typical loan, the interest paid doesn’t go to a bank or outside lender — it’s credited back into the borrower’s own retirement account, which is one of the more distinctive features of borrowing this way.
How the rate is typically set
Plan documents usually specify a formula rather than negotiating rates individually, most commonly “prime plus” a set margin, reviewed periodically as the benchmark rate moves. This differs from an adjustable-rate mortgage, where rate resets happen on a defined schedule tied to an index and margin, in that most 401(k) loans lock in a fixed rate for the life of the loan at the time it’s originated, rather than adjusting afterward. Because the exact rate and the benchmark used can change over time and vary by plan, this is illustrative rather than a number to rely on for a specific loan.
Why the interest goes back to you
The core structure of a 401(k) loan is that the participant is borrowing their own vested balance, and the plan requires interest as part of that borrowing arrangement — largely to reflect the fact that the money is out of the market and not earning investment returns during the loan term. Rather than paying that interest to a bank, it’s deposited back into the same retirement account the loan came from, alongside principal repayments. In effect, the borrower pays interest to themselves, which is different from how personal loan interest works, where the payment compensates an outside lender.
What this means in practice
- It’s not “free” money even though the interest returns to you. The bigger cost of a plan loan is usually the lost investment growth on the amount borrowed while it’s out of the market, not the interest rate itself.
- The rate is generally lower than many other borrowing options. Because there’s no profit margin being built in for an outside lender and no credit-based pricing, the rate set by a formula like prime-plus-one tends to run lower than unsecured personal loan rates, though this varies by plan and by market conditions.
- Interest still accrues on the outstanding balance. Payments are structured similarly to an amortization schedule on other installment loans, with each payment covering both interest and principal until the loan is paid off.
What to weigh
Because the interest ultimately lands back in the borrower’s own account, some people view a 401(k) loan as a relatively low-cost way to borrow compared to other options. The tradeoff worth weighing is the opportunity cost — money withdrawn from the market during the loan term doesn’t participate in any gains (or losses) it otherwise would have, and that effect can be larger or smaller than the interest rate itself depending on how markets perform over the loan’s term.
The bottom line
A 401(k) loan’s interest rate is typically set by a simple formula, and unlike almost any other kind of borrowing, the interest paid flows back into the borrower’s own account rather than to a lender. That structure makes the “cost” of the loan less about the interest rate itself and more about the investment growth given up while the balance is out of the market — worth thinking through before treating the low stated rate as the full picture.