Should I Take a 401(k) Loan to Pay Off My Credit Card?
I’ve dealt with 401(k) plans pretty extensively over my time in this industry. Most specifically while I worked for Fidelity Investments and helped companies run their 401(k) plans. Recently, I was quoted in Consumer Reports on this topic and I wanted to share my full thoughts here.
First, I’m always a fan of getting out of credit card debt (or just about any debt). I don’t care if it’s inflation, deflation or stagflation, the interest rates are too high to carry a balance. But, am I a fan of a 401(k) loan to get out of debt quick…typically not. I’m going to provide an overview of how 401(k) loans work and then explain why I’m usually against them.
Overview of how 401(k) loans work:
First, 401(k) loans are not required to be offered! So if your plan doesn’t provide the option for one, they are well within their rights.
How much can you take: The mechanics of a 401(k) loan are this: you can borrow the lesser of $50,000 or 50% of your vested account balance (that’s eligible for a loan). Your employer may not have all sources of money (your contributions, match, profit sharing, etc.) available for loan. They get to decide that as they run and design the plan. There is also usually a limit on the number of loans that can be outstanding or taken in a year and rules that come into play if you already have a loan outstanding and want to take another (i.e. the amounts get reduced)!
For example, if you have $40,000 and it’s all vested, you can take a loan for $20,000 - assuming no other loans have been taken. If you have $160,000, then the maximum kicks in and you can take $50,000. I’ll spare you the head spinning if you have multiple loans, but just know you can’t have more than $50,000 outstanding and a second loan must take into account the highest outstanding balance over the past 12 months. Call your provider or visit their website to view your specific details.
Fees - There are usually fees associated with taking a loan. There may be a loan origination fee and/or an annual maintenance fee. Typically loan origination fees are $125-$175. Annual maintenance fees may range from $50-$75.
Types & terms of loans: There are two types of loans that you can get: a general loan or home loan. While interest rates can differ, the primary difference is in regard to the maximum time term of the loan. You can typically have a general loan paid over 5 years and a home loan paid over 10 years. When you’re looking to take money out to pay off another loan, you’d be looking at a general loan and a maximum of 5 years.
Interest Rates: Then you have interest rates. Not all interest rates are the same across all plans believe it or not. There are rules that go into setting them, so you should check with your 401(k) provider on the rate you would be charged. Typically, you find plans that have tied the rate to Prime + 1% or 2%. Today that’s 4.75% + 1% or 2%. Again, you should check with your 401k provider. It’s important to note that interest is paid back to yourself, not the 401k provider. This doesn’t necessarily make it a good deal! On a $50,000 loan at 6% interest for 5 years, you’d pay yourself back $7,920 of interest. If you left that money in your 401(k) plan for 5 years and it earned an average of 6% over that time, it would grow to $66,911 (earning $16,911). This is a simplistic example and returns of your investments play a key role in it too. Obviously, your debt situation has to be taken into account, but you can see the difference.
Payments: Most 401k plan loans come through payroll deductions. You, the participant, need to make sure the payment is deducted and credited to your loan. While you may think this is required of your employer to do, it’s not. It’s your loan, not theirs. Some plans have it set up to where you can pay directly from your bank account and that makes it much easier. Some providers also won’t let you make additional payments if you want to pay it down a bit at a random point in time. It’s often an all or nothing kind of thing. If your loan defaults while you’re still an employee, it’s treated like an early distribution and you’ll have to pay taxes and penalty. The loan will also remain as part of your 401(k) account with that specific plan. It will continue to accrue interest and you’ll likely have to pay it off before you could take another loan.
Change of jobs: Finally, if you leave your job, you need to have a plan for how to get that loan paid for or see if your new employer will accept the loan into their plan for continued payment. There can be steep tax consequences if it defaults (10% early withdrawal and ordinary income tax). Historically, you had 60 days to take care of this after you leave your company, but the SECURE Act passed at the end of 2019 allows you to repay it in full to your IRA by your tax filing deadline. You cannot have a loan in your IRA.
Now that you know how 401(k) plan loans work, should you take one or not?
As a general rule, I believe 401(k) loans should be avoided at all costs. Unless you like paying Uncle Sam twice on the same dollar, it’s typically not a great idea. 401(k) loans are paid with after-tax dollars. So, if you put money in pre-tax, borrow it (no tax on the borrowing), then repay with after tax dollars, then you withdraw in retirement and pay taxes on it again! Plus, when you change jobs, this will be an added stress of how to pay it all off or see if you can roll it to your new employer (and they aren’t required to take it). If you take the loan for 5 years, you’re possibly missing out on investment returns as well. Finally, I’ve seen that when a person takes one 401(k) loan, they usually come back for more and that is detrimental to your plan for retirement. So, while you may get money out quickly to pay for or pay off something else, you may not be fixing the root cause of the issue here.
So what to do?
Create a realistic budget and stick to it. Most often (not all the time), we get into credit debt because we don’t like to tell ourselves no. But, us mere mortals have a limited amount of money that comes in and a limited amount that should go out. You may need to look hard at your situation to see what can be cut or needs to be cut. If you can’t do this, you’re just robbing Peter to pay Paul if you take a 401(k) loan. If you’ve cut as much as you can, then it’s an income issue and you need to think through your options on that side of the equation.
Focus on paying down debt fast. I prefer the snowball method of paying off debt. Pay all of your minimum payments and focus on all extra money going towards the smallest balance first. Once that’s paid off, it’s not free money in your budget, it gets thrown at the next one in line until you’re tackling your biggest debt last. Some don’t like this because mathematically it may not make sense. However, when people get small wins from paying off debt and seeing the fruit of their labor, it empowers them to keep going (it did for me). I like what works in real life vs what works on paper.
Reduce 401(k) contributions or stop completely. If you hate your credit card debt (or any other consumer debt) enough, you should consider contributing the minimum to your 401(k) to get the match, if your plan offers a match. If they do not offer a match, I would say consider stopping 401(k) contributions all together and throw that money into your debt snowball. This is not a forever thing, it’s short term to accomplish your goal of getting out of debt. Think about it, the average credit rate is around 16%. Depending on when someone looks at market returns, they may quote around 8%. If that held true, I would be getting double my money’s worth on paying the credit card over putting it in the market. The credit card company is guaranteed to charge me 16%, but the market is not guaranteed to give me 8%.
0% Balance Transfer. Depending on the amount of credit card debt, you may look at a 0% interest balance transfer if you can get it long enough to accomplish the goal. Don’t mess with this if you won’t realistically stick to the plan because you’ll be back charged all the interest if you go past the introductory period.
Part time job. This is another option if you want to really kick it quick! There are options to do this from home or for a brick and mortar employer.
It can be done, I’ve done it with consumer debt, and others have done it as well - without getting a 401(k) loan. It takes passion and you need to figure out why you want to do this, but there is a way! At a minimum, I hope you now understand how 401(k) loans work and some of the pitfalls they can have. If you’re looking for help and bringing all of your financial matters together in a customized plan to fit you, then click the Schedule Appointment button at the top of the page to learn more how I can help!
