Since the beginning of the credit crunch, many of us have been looking for creative ways to pay off debt. One option I considered was to take a loan out against my 401(k). Here are some of the pros and cons of using your retirement account to pay off debt.
Borrowing from Your 401(k): Hardship Withdrawal Considerations
The Benefits of 401(k) Loans
The biggest benefit of borrowing from your 401(k) is that the only qualification criteria involves having an account with money in it. No other loan product on the market allows borrowers to qualify so easily. But the benefits don’t stop there:
- The interest rate on your 401(k) is usually much lower than any other traditional loan product on the market, which allows you to instantly lower your monthly payments.
- Your payments are generally spread over 5 years and are fixed. This helps reduce your monthly costs while shortening the amount of time it will take you to pay off higher interest, open ended credit lines such as credit cards and home equity lines of credit.
- In some instances, like borrowing to buy or build a home, you can extend your repayment over 180 months.
- The interest that you pay on your 401(k) loan goes back into your retirement account. You are actually paying yourself back for the loan!
- You can borrow any amount from your 401(k) as long as it doesn’t exceed ½ your balance or $50,000. This means that you can borrow what you need.
- In most cases, the 401(k) loan payment is directly deducted from your paycheck, keeping your loan current and preventing the possibility of large penalty fees and interest.
The Dangers of Borrowing from Your 401(k)
Keep in mind that while all of those attractive benefits make borrowing from your retirement account look like a slam dunk, not everything is as rosy as it seems. Believe it or not, there are some pretty significant drawbacks to taking this approach! First and foremost, you are not simply eliminating debt by taking out a 401(k) loan; you are simply replacing one payment with another.
The idea behind obtaining the loan is to use it to pay off more expensive debt so that you can eventually become debt free. In many, cases, however, individuals will pay off credit cards and other loan products with a 401(k) and then simply run the balances back up, saddling themselves with their original loan payments PLUS a new loan payment to boot. Some things to watch out for:
- If you leave or are fired from your current job, most plans will require you to pay back the loan IN FULL within 60 days of your last day. This can hurt if you have taken out a large loan and do not have the means to pay it back quickly.
- The money you have taken out in the loan will no longer be working for you, earning interest in your retirement account. This will have a significant impact on your future balance.
- You are forbidden to continue making contributions to your 401(k) while you have an outstanding loan balance. This, coupled with the loss of any gains on the loan balance, will impact your future retirement balance significantly.
- Lastly, your tax burden will increase due to the fact that your 401(k) contributions are no longer being deferred.
Alternatives to 401(k) Loans
If the thought of having to borrow from your retirement account makes you a bit squeamish, you might want to consider alternative forms of paying off your debt. Here are a few you can consider:
- Balance transfer credit cards. Yes, there’s a risk with dealing with new credit cards, but if you have good credit and are pretty disciplined, you can take advantage of 0% intro rates and terms from certain credit cards to make a major dent in your card balance. Just make sure you pay off your transferred balance before your intro period expires and rates are readjusted upwards. Here’s where to check out more information on 0% balance transfer credit cards.
- A peer to peer lending network. Check out Lending Club or Prosper. Again, if you’ve got good credit, you can join a p2p lending network and apply for relatively cheaper personal loans. You can read more about such networks in our Lending Club review.
- Debt consolidation loans. One way to get lower rates and consequently, lower debt payments is by rolling all your loans into one cheaper loan. The general term for such a loan is a debt consolidation loan, but be aware that there are pros and cons to taking out this kind of debt.
- A home equity line of credit comes as close as you can get when it comes to mimicking the benefits of a 401(k) loan. The interest is usually slightly higher and the loan limits may be more restrictive based on your current credit situation, but in many cases, you can borrow at least as much, if not more than you could through a 401(k) loan. Plus, the interest you pay on a home equity line of credit is tax deductible.
- A home equity loan is another option when it comes to finding a comparable loan product to pay down debt. Like a 401(k) loan, a home equity loan, or second mortgage, is a closed end loan product with a fixed interest rate. The main difference is that the interest rate is usually higher than that of a 401(k) loan. However, since the interest is tax deductible, the ultimate outcome is that the tax break you receive, when factored into the interest rate of the loan, may make the interest on this type of loan actually less that the 401(k) loan.
One of the major drawbacks to both a HELOC and second mortgage is that not everyone will qualify. You must have decent credit, some equity built up in your home and a stable income. All of these things are tough to come by in the current economic climate. The other drawback is that your house is on the line if you have to default for any reason.
Of course, the debt consolidation plan you choose will need to take into account a multitude of factors including your ability to access credit, how much debt you have vs. how much money you need to pay it off, and how stable you are in your job. Given all these options, you’ll need to gauge which is the best kind of loan for your needs.