Reader Vj dropped by with the following question:
If you have $10,000 worth of credit card debt at 10% interest would it be advantageous to get a loan from your 401K to pay it off and pay yourself back?
According to Liz Pulliam Weston over at MSN Money, this is one of the 7 most common 401(k) blunders. I’m not sure things are so black and white, but here’s what her article says:
What seems like a great idea — Borrow your own money! Pay yourself interest! — has plenty of traps for the unwary:
~ The biggest pitfall is the risk you take should you lose your job. Your loan would become due, and, if you couldn’t pay it back at once, you would owe income taxes and penalties on the unpaid balance.
~ The interest rate you pay yourself may be lower than what you would pay most other creditors, but paying yourself interest is no substitute for the real return you would be earning if you had invested those payments instead.
~ Borrowing from your retirement funds is often a sign that you’re overspending — particularly if you’re using the proceeds to pay off credit card debt. People who use “easy outs” like 401(k) and home-equity loans to pay off their cards often don’t change the underlying behavior that put them in the hole. They just run up their balances again, winding up another day older and deeper in debt.
There are several great points in there, but in the end it is still a possibility. But I would rank it as a “last resort.” Then again, if you’re having trouble paying your credit card debt, wouldn’t you also have trouble paying your 401(k) loan?
There are some definite alternatives you should look into first. Try this:
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Find some “0% APR for one year on balance transfers!” credit card offers. These are very common - Chase is offering it on their Freedom card, currently. There’s always several floating around. Read over the terms, but don’t apply yet.
Call up your current credit card company, and tell them, firmly but politely, that you’re going to get this 0% balance transfer, and move your money off their card. Chances are, they’ll offer you a lower rate. Take it. This way, even if you can’t move your money, or if you can only move some of it, you have a lower rate on the original card.
Apply for that 0% balance transfer card, and hopefully, you’ll be approved. Move as much of the balance as you think you can pay off before the introductory rate ends. This part is very important. If you can’t pay off the whole $10,000 before the intro rate is up, and the regular rate isn’t better than your original card(s), then only move what you can pay off in the year.
This plan assumes that you’ve been making regular payments on all of your cards and bills, and thus have a clean enough credit history to qualify for a 0% intro rate. Since the original question had 10% interest rates on the credit card, that’s a pretty safe assumption (if your recent credit history was bad, you’d be looking down the barrel of 30+%!).
All in all, the 401(k) is not the first place I would look, not by any means. Do you have savings sitting around earning less than 10%? Do you qualify for a Lending Club loan at less than 10%? Is there anything you can trim down in your budget to free up some more funds for paying down this debt? If you can’t spend less, can you think of any ways to earn more?
Oh, and cut up the card(s) until it’s paid off. Once it is paid off, if you feel that you can use it without carrying a balance month-to-month, you can always call up the card company and have them issue you a new one. But no matter what method you use to pay down your debt, especially if it’s a loan from your 401(k), the key is to not charge anything more to that credit card.
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43 responses to “Reader Question: 401(k) Loan to Pay Off Credit Card?” 
Hey,
First off, congrats on the site move. The new site looks AWESOME!
Second, I agree with you that trying to borrow from other sources to pay off the CC is a good idea. However, (a) 10% for a CC is actually pretty low and so I don’t think you need to resort to extreme measures, and (b) if you are actually desperately trying to pay off that CC, you may be in fiduciary trouble that will prevent you from borrowing more.
Basic financial convention suggests that taking a 401k making about 10% a year to pay off a 10% CC just about breaks even. However, in this case, I would still hold the 401k, as there is a change that the 401k’s return rate can increase while at the same time, forces you to be more responsible with debt (since you know you have to pay off the CC before incurring more).
If i had the money sitting there I’d clear the debt.
Stubsy,
Which “there” are you talking about? If you mean savings or anything of that ilk, I agree. However, 401(k) investments aren’t exactly “sitting there” - you can’t get at them without some sort of penalty.
I was just thinking about this concept this morning, the first day I am eligible for and fully vested in matching funds from my employer.
I think the penalties for withdrawal are almost negligible if you are receiving a 100% match from your employer. Only if you hadn’t intended on investing that money in the first place. Why not jack your contribution up to the max matching rate for a few months, and then take a loan out to pay of the credit card debt. Whether or not you take a tax hit (what, an extra 10%??), you still made buku bucks on the match.
Stefanie,
Even if the math works, it’s still an extremely risky loan, due to the fact that the entire thing is due back in full if you lose your job. I would still recommend people seek out other options first.
A final note about borrowing from a 401(k). When you borrow from a 401K, you get getting pre-tax money out. However, you have to repay with post-tax money. If you do the math, this means you pay a penalty equal to your marginal tax rate for the borrowed money.
As for employer matching — that’s not “free money”. That’s part of your compensation package where if you went to a competing employer who didn’t offer a 401K, they would have to pay you a higher paycheck for the same work/skills/situation. What’s really happening is you have the option of giving back some of your pay to your employer by not contributing to the 401K.
Here is what I don’t get though; you can still make contributions while you’re taking the loan out, and the interest you pay on the 401k loan goes back into your account. So as long as you feel stable in your job, isn’t this still a good idea?
This comment: “Yeah, but you’re paying off the 401k loan with AFTER tax money, so you’re being penalized”, is irritating because it doesnt consider the alternative. Guess what folks, you’re paying off credit card debt with AFTER tax money too.
What no one talks about is the more likely case where folks are paying much more than 10% interest rate on their credit card. CC interest rates are rising. many cards are easily past the 16% mark.
Which is better, losing big money on high CC balances with high interest rates, or paying a similar monthly payment WITHOUT suffering hundreds of dollars in lost interest (this particular case uses a high-debt situation as an example)?
The pitfall of continued high spending and job loss is still valid, but nothing I’ve read here convinces me it’s better to pay high interest on high CC balances while ignoring a 401k loan plan.
If you don’t qualify for a zero pct intro APR with a CC, then you have to look at the 401k option, IMHO (provided home equity is not an option).
IMO, this is an awful way to pay off debt. You’re going to pay more than 10% in fees when you withdrawl early. So you can almost think of it as being a 10%+ interest loan, couldn’t you?
@Tom: A 401(k) loan is different from a withdrawal - you would only incur the 10% penalty if you switched jobs or otherwise failed to repay the loan.
But you do bring up the reason why a 401(k) withdrawal is ALSO a poor way to pay off debt!
You also need to bear in mind that Consolidation Loans may not always be the best option for certain individuals. If you cant afford to make repayments or if you have a bad credit history then some lenders will charge you even more on interest rates, putting you further in debt in the long run.
Taking out a consolidation loan in certain situations can be a great help, if, and only if you can control your spending and if, and only if, you get rid of all that ‘plastic’ that may have got you into debt in the first place.
Yeah, the whole issue of having to make payments if you lose your job make sthis far too risky. In the UK you can at least have insurance cover to make payments for a specific period of time. Although not a long term solution it could be a stop-gap option.
I think taking a low interest loan from your 401 k is an great idea, if you cut the credit cards up. Paying back the 401k you choose the time in which to pay back and its automatically deducted from your paycheck. Good luck.
What is a Prosper Loan? Never heard this term before. Thank you.
@Valerie: A Prosper loan is a loan through the person-to-person lending service, Prosper. There’s a link in the entry that explains a bit more about the service.
It would be better to just cut off your expenses, I am sure that in 90% ot the time this can be done. Try earning more, if not.
If you take money out of your 401k to pay off your debts, you may regret it later. Taking out a loan or an early withdrawal will reduce your eventual retirement account and may force you to work longer.
Finding 0% APR cards is my preffered way to initially handle debts. Plus you can move around fromo lender to lender after the introductory period, which can be up to 6 months. You can literally save youself a ‘bundle’ with just this one method.
Taking out a 401k loan to pay unsecured debt is always a bad idea, because 1) you are securing your debt, and 2) now you don’t have as high of a balance-to-credit limit ratio, so your credit score goes up, you end up with additional credit cards/limits, and you end up spending the money on the same credit cards again anyway. So now you effectively doubled how much you owe….never mind what happens if you lose your job/default on your 401k.
I’m in that situation now…I first consolidated all my credit card debt with a 16% loan…..It kills me ever month to see the interest I pay to these companies…I feel my only option is taking a 401K loan as expensive as it is…banks keep me in the poor house……I feel I will not reload the cards and I will live as much as I can without CC’s. I really want out debt is the biggest stressor in my life…..I want it to end…..thanks for the forum….
@Robert
Have you looked at trying to get a credit card with a 0% APR intro rate? Not to spend more, but just to transfer the balance. Failing that, have you looked at Prosper Loans at all?
Thanks Stephanie…I did transfer part of my expensive loan to a 6 percent loan….but of course there was the 3% fee on top of that….
Thanks for the info on Prosper Loans…I will look at that more tonight when I come home from work.
Best Regards,
Robert
GREAT LOOKING SITE!!! if you are trying to pay of some debt….you might consider a balance transfer with a credit card. Most balance transfer credit cards are at 0%. By taking out your 401k you might get taxed alot and it might not make sense if you are in debt already. Check the numbers first before anything.
Stop talking about tax implications on a 401K LOAN!! You’re killing me here! You are NOT taxed on a LOAN only a WITHDRAWL.
@Frustrated - you’re right, but as I said in the article, you COULD be taxed if you lose your job and can’t repay the loan, because it then becomes a withdrawal.
Here’s my comment…. I have taken a 401k loans in the past where I have paid them off with no problems, switched jobs and the loan switched with me, and switched jobs again and the loan would not move with me. In the last instance I was hit with the penalty and I’m paying for that now. But even still, this is a great option I believe for a couple of reasons. 1. I was able to reduce my interest debt and invest in a new business with my husband. 2. I was paying myself back with interest instead of the credit card company. 3. The interest I was repaying myself was more than the interest I was getting from my 401k investments. Now, if you lose your job for any significant amount of time, won’t you tax burden be less because you don’t have the income? If I had lost my job instead of getting a new job, my taxable income for the year would not have been as much and the penalties for what became a withdrawl could have netted out the lost of income for the year. In a perfect world, we could let our 401K sit there and make us tons of money, but when it comes to loosing your home or borrowing against your 401K, I would highly recommend borrowing against your 401K. Well, that’s my two cents.
If youdon’t have the option of transfering balance to a lower apr then a 401k loan is not a badd idea.
The only risk is if you lost your job and you could not repay within 60 days window.
In my case, I have over $7K in 24% APR on CC and 401k offered me %6 apr on a loan- when planning to repay in 12 months, I found that i saved myself over $1200is only 6%.
CC companies are ripping me off and I tried everything to negotiate my apr with them but had no luck…
Lastly, even though I am paying myselft the 6% apr, but remember guys that when the 401k matures, you will pay taxes over the incurred interests.
I’ve almost done this with my 401k but held back in the end. Glad I did and I think things will rebound in about a year from now.
Would anyone find it beneficial to withrdraw my whole 401k if I’m looking at 15k in credit card debt at 30%APR. I was late a few months on my payments and I can’t get it down nor get a new cheaper card. Also any idea on when I could take the 401k out without having to pay it on my 2008 tax? I’ve been buried for 4 years now and I just need to get out
Charles, I would think long and hard about touching your 401K if you are under 50 years old. It will rebound and eventually make your more money than you think.
Do you have real estate? You could consider a HELOC. Please leave more information.
Nothing else of value, late twenties, not making a great chunk of change but hoping to change that. I’ve just been stuck under this credit card debt for so long and now it seems like I need some breathing room. I was thinking about just sucking it up and taking it out after this tax year is over, hoping to make more money next year and just starting from scratch. It’s not a ton of money in my 401k, maybe 7k, but it will allow me some breathing room and knock my monthly payments down a lot. I know it’s just delaying the problem, but at this point i was hoping for some room to make things more manageable once I start to make a bit more.
Thanks again for the response!
Sorry, no real estate so that knocks out Heloc.
@Charles: Trent at the Simple Dollar had a reader ask him almost the exact same question. You can read his response: Emptying out a 401(k) to pay off credit card debt.
I’m on the fence about this. It can only work if you completely cut up your cards, and work hard to pay them off completely after you do this, and then work hard to replace the money in your 401(k). It’s best to have a plan as to how much money you’re going to put away each month, and then try to exceed that.
To answer your question, I would assume you can put the tax penalty off by waiting until January to do this. Do yourself a favor, and estimate how much your taxes will be on it (depends on your tax bracket), and put that money aside in a savings account to pay the tax bill when it comes in 2010. Use the interest from the savings to help pay off the remainder of your debt!
Like I said, this is only going to help you if you’re very disciplined about it. Best of luck!
Also when could I withdraw w/out having to be hit w/ the tax/penalty for 2008? I know it’s putting the problem off but I feel that with a year of strict budgeting I can get things under control.
@Charles: Like I said, you can likely avoid the 2008 tax bill for that if you wait until January, 2009.
But I’ll tell you something, I figured out why this idea makes me uncomfortable, and this is it: stocks are down right now, way down. So your 401(k) has probably lost some value lately. But, the thing is, you only really lose money if you sell while it’s down. A withdrawal would be selling! Whereas a loan against your 401(k) would not be. Food for thought?
I’ve been watching this thread the last few days and it’s seems to me Charles that for the amount of money you owe, I would consolidate your debt and change your personal income and out-going ratio - that is code for pain
Stephanie is right - you don’t want to sell while you are down in the market. Things will turn around. I’ve personally lost over 35K due to the global economic downturn, but I have no intention of selling off any of my 401k.
Personally I dont think it ever a good idea to borrow money from your 401k.
Hmm,i would not borrow money….ever.
Wait a second, use a 401(K) to pay off a credit card? As said before, you can’t just go and pull all of your money out of a 401K without a penalty. This is something I think would be best speaking with a investment advisor about.
Does anyone have any information on these Debt Consolidation companies? Or even perhaps one that you’ve used/heard is legit? I’m looking to shed $15k in credit card debt amongst 3 cards but I can’t get my interest rates down and have been struggling w/ the monthly payments.
Personal loans can be paid in easy installments, it looks better on paper than the revolving credit of credit cards. The fact that a personal loan has no compounded interest makes it a better alternative to get rid of your credit card debts.