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Q&A: How are interest rates determined on a 401(k) loan?

Tracy St. John
by Tracy St. John, The Garrett Network  (@FinancialAvenue)

When employers choose to offer their employees the benefits of a 401(k), the employers then have the option of adding a loan policy. In addition, the employers also choose what interest rate will be used to pay back the loans.

The typical interest rate chosen is the “prime rate” plus one percent, although I have also seen two percent used in some plans. The “prime rate” is the most widely used benchmark for setting home equity lines of credit and credit card rates. For the past year, through July 11, 2012, the prime rate has been 3.25% so a typical interest rate on a 401(k) loan would be 4.25% or 5.25%.

READ: Understand the 401(k) rules

Employees should be aware that the employer also determines the reasons for which a loan can be taken. For example, one employer may allow a loan for any reason, while another employer may restrict the loan to uses like the purchase of a first-time residence, payment for post-secondary education or un-reimbursed medical expenses.

To determine your 401(k) plan interest rate, locate your retirement plan's summary plan description (or SPD) or contact your human resources department to obtain a copy.

 

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Tracy St. John is the founder of Financial Avenues, LLC, a Fee-Only financial planning and investment advisory firm. She obtained her Masters Degree in Family Financial Planning as well as a Certificate in Personal Financial Planning through Kansas State University.