The interest rate on a 401(k) loan is typically the prime rate plus one or two percentage points, fixed at the time the loan is issued. With the prime rate at 6.75% in early 2026, most borrowers see rates between 7.75% and 8.75%. Every dollar of interest you pay goes back into your own retirement account rather than to a bank, but that arrangement carries tax costs that make the rate on the paperwork misleading as a measure of what you’re actually paying.
How the Rate Is Set
Plan administrators tie the rate to the prime rate, which is the baseline that commercial banks charge their most creditworthy business customers. The Wall Street Journal publishes the widely referenced version, and most plans use the figure from the last business day of the month or quarter when your loan is processed.
The standard formula adds one or two percentage points on top. Your plan’s governing documents spell out the exact markup, and you generally cannot negotiate a different rate. Whatever rate applies locks in the moment the loan is issued, so if the prime rate rises or falls during your repayment period, your rate stays the same for the life of the loan.
The IRS does not set a specific rate, but Treasury regulations require that any loan from a qualified plan carry an interest rate and repayment terms that are “commercially reasonable,” meaning the rate must be comparable to what you’d pay a local bank for a similar loan.1eCFR. 26 CFR 1.72(p)-1 – Loans Treated as Distributions A plan offering 0% interest would fail this test, and the IRS could reclassify the entire loan as a taxable distribution. An unreasonably high rate could look like an attempt to funnel extra money into the plan beyond normal contribution limits. This is why the prime-plus-one-or-two formula is nearly universal: it sits comfortably in the middle of what commercial lenders charge.
Where Your Interest Payments Go
When you pay interest on a credit card or bank loan, the money goes to the lender. When you pay interest on a 401(k) loan, it goes back into your own retirement account.2Internal Revenue Service. Retirement Topics – Loans The interest follows your existing investment elections, so if your balance is split between a stock fund and a bond fund, the repayments are invested in those same proportions.
That sounds like a good deal, and in some ways it is. But there is a tax wrinkle that changes the math. Your regular 401(k) contributions go in with pre-tax dollars: you have not paid income tax on that money yet. Loan repayments, including interest, come out of your take-home pay, which is after-tax money. When you eventually withdraw that money in retirement, the entire balance (including the interest you repaid) gets taxed again as ordinary income.3Internal Revenue Service. Retirement Plans FAQs Regarding Loans The interest portion of your repayment effectively gets taxed twice: once when you earn the income to make the payment, and again when you withdraw it in retirement.
The interest is also generally not tax-deductible. Federal law denies the deduction for interest on plan loans secured by elective deferrals, which describes most 401(k) balances, and for any loan to a key employee.4Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Compare that to a home equity loan, where interest on money used to improve the home can often be deducted, and the effective cost of the 401(k) rate looks steeper than the number on the loan agreement suggests.
The 6% Cap for Active-Duty Military
Active-duty military personnel receive special protection. Under federal law, interest that accrues on a 401(k) loan during a period of military service is generally capped at 6%, regardless of the rate in the original loan agreement.5Internal Revenue Service. Retirement Plans FAQs Regarding USERRA and SSCRA The cap is not automatic. You need to provide a copy of your military orders to the plan sponsor and request that the limit be applied. Plans may also suspend loan repayments during a military leave of absence for up to one year, though any missed payments must be made up afterward so the original loan term is not extended.3Internal Revenue Service. Retirement Plans FAQs Regarding Loans
The Real Cost Beyond the Rate
The interest rate on your loan statement does not capture the full cost of borrowing from your 401(k). When you take money out of your retirement investments, those dollars stop earning market returns for the duration of the loan. Even if you are paying yourself 8% interest, your investments might have earned more (or less) than that during the same period. Over a five-year loan term, the gap between the interest you pay yourself and the returns you miss out on can meaningfully affect your retirement balance.
There is a secondary cost that is easy to overlook. If repaying the loan each month squeezes your budget, you may contribute less to your 401(k) during the repayment period. Fewer contributions over five years mean fewer years of compounding growth on those dollars, which can add up to a significant shortfall by retirement.
Before borrowing, weigh the all-in cost against the alternatives. A home equity loan or a personal loan may carry a higher headline rate but avoid the double taxation on interest, and in some cases the interest is deductible. The rate quoted by your plan is the starting point of the analysis, not the answer.