Reader Question: 401(k) Loan to Pay Off Credit Card?
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:
-
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 Prosper 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.
Other Links: debt consolidation loans may not be your best option, Learn the Secrets to debt free living. Our certified counselors will structure a debt solution that works for you.
Reader Question: Student Loan to Pay Off Debts?
Reader Question: Debt Consolidation Loan?
Reader Question: Credit Card Hardship
Financial Aid Dilemma Resolved
Reader Question: Better Credit Today?
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).
Comment by Finance Guy — March 20, 2007 @ 10:18 pm
If i had the money sitting there I’d clear the debt.
Comment by stubsy — March 21, 2007 @ 5:28 pm
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.
Comment by Stephanie — March 21, 2007 @ 5:43 pm
[...] Poorer Than You Endless Giberish We’re In Debt Credit Card Lowdown B.A. Student 1 Mans Money The Time and [...]
Pingback by No Credit Needed Blog » Blog Archive » Carnival of Personal Finance #94 Hosted By No Credit Needed — April 2, 2007 @ 7:24 am
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.
Comment by Stefanie — April 2, 2007 @ 4:24 pm
[...] Poorer Than You writes about paying off debts. Should you borrow from your 401K to payoff your debts? Here’s a quote from the article that I think “speaks volumes”. 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? [...]
Pingback by No Credit Needed » Blog Archive » Carnival Focus: Credit Posts — April 2, 2007 @ 6:05 pm
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.
Comment by Stephanie — April 2, 2007 @ 10:19 pm
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.
Comment by MossySF — April 3, 2007 @ 9:16 am
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?
Comment by Kathleen Ford — June 27, 2007 @ 2:44 am
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).
Comment by Gmoney — August 24, 2007 @ 3:00 pm
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?
Comment by Tom — December 21, 2007 @ 8:01 pm
@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!
Comment by Stephanie — December 22, 2007 @ 8:55 pm
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.
Comment by Your Consolidation Loan Ltd — January 18, 2008 @ 10:08 am
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.
Comment by PH from Bad Credit Remortgage — February 7, 2008 @ 9:05 pm
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.
Comment by Jamie — February 29, 2008 @ 9:33 am
What is a Prosper Loan? Never heard this term before. Thank you.
Comment by Valerie — February 29, 2008 @ 10:23 pm
@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.
Comment by Stephanie — March 1, 2008 @ 6:41 pm
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.
Comment by Jane Doe — April 28, 2008 @ 12:55 pm
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.
Comment by Janni — April 29, 2008 @ 9:59 pm