Borrowing from 401-K to wipe out a debt - good idea or not?

[Green Lantern]

In one way, it seems like a no-brainer:

Interest on 401K loan = I guesstimate about 10% (more on that below) - Paid to MYSELF...

Interest on Credit Card = about 20%

Loan would be used to either pay off my credit card or my car.  I owe just shy of $5k on my card, and a little less than that on my car.  BTW, I plan on keeping that car for as LONG as I can!!!

Now, er, I've already taken out two smaller loan on it - one is paid off in a few weeks, the other should be paid off in about 2 years...   This is why I don't know for SURE what the interest rate would be.

I know, I KNOW...I promise I'll be good this time if I can get (relatively) debt-free!

But now - assuming I DO NOT take the loan:

The car will be paid off next September.

The card, SHOULD be paid off by this time next year at the VERY LATEST.  Well, barring any 'troubles.'

That's pretty close...but still, I wonder if it'd be worth it to save on interest charges...?

[Ben]

I can only give you anecdotal information. Anyone I've ever talked to that has used their retirement fund to pay off debt, put money down on a house, or just taken it out when they left a company or the govt has told me they regretted doing so. Many who switched jobs and had the option of putting money back in but didn't, regretted that as well.

If you're in debt, you gotta do what you gotta do, but definitely consider the long term when looking at using your retirement money.

[wmenorr67]

You have to figure in the penalties you may incur from removing money from a 401K early.

Best advice is to talk to a financial advisor.

[ilbob]

Borrowing from a retirement plan sometimes makes sense, and sometimes it does not.

Whatever gains you would have on the funds in the plan will be lost for the amount borrowed, and if you are forced to not pay it back later on, it becomes a taxable event, with penalties.

OTOH, you pay no interest.

$5000 is not a huge amount of money. Most people can pay off such a debt in a year or two if they really want to.

I would also suggest that it is possible you can get a much better unsecured loan than 20%. You might be able to get the rate reduced just by calling the CC company and asking.

[grampster]

Financial adviser will tell you to not borrow the money.  They will have all sorts of esoteric reasons why not.  I will tell you to not borrow the money for one simple reason:  It's the easy way to get yourself in deeper trouble.

As the great Walter Hagen said about tactics to recover from a bad golf shot:
"It did not take a good shot to get you into that trouble...what makes you believe you can make a good shot to get it out?"

The same thing applies to debt.  It will be a better exercise for you to condition yourself to be more responsible with your money by focusing ALL of your efforts on paying off the car and the card early and not make another bad decision regarding your 401k.  Cut up all of your credit cards.  Keep your car in good running order by paying attention to maintenance.  Get a part time job and put all the take home pay against your debt.  Live frugally while you are doing this.  It will be good not only for your self confidence but your spirit as well.

Good luck.

[K Frame]

HORRIFICALLY BAD IDEA!

[Leatherneck]

Grampster hit the nail on the head. Use your current situation to modify your behavior/expectations as necessary and benefit more in the long run.

TC

[Northwoods]

Bad, bad, bad, bad idea.  Why?

1.) It doesn't change the habits you're in that got you into consumer debt.
2.) If you don't pay back according to the rules you get hit with your full tax rate on the outstanding amount plus a 10% penalty.  Total hit is 30-50% depending on your tax bracket.
3.) When you leave the company the balance of the outstanding loan amount is due in full within 60 days.  And you will leave the company at some point.  Death counts as leaving and do you really want your spouse to have to face the payback requirement right after burying your butt?  Layoffs count as leaving too.  Do you really want to have to face that kind of financial stress when you are out of work?
4.) It's still debt.  You're just rearainging the deck chairs.
5.) You've unplugged yourself from the stock market to the tune of whatever the loan amount was.  Yeah, the market's not doing great right now, but that can change and then you're missing out on all the gains.
6.) You can only pay it off early by one single lump sum for the whole amount.

What you need as much as anything else is a better game plan going forward.  This mean doing a written new budget before each month begins allocating that month's income on paper, on purpose and sticking to that plan.  If you're married both you and your spouse need to do said budget together and come to an agreement on how to prioritize your spending, savings and giving.  Make sure your both have an equal vote in the process.  Then once it is agreeded upon, neither of you gets to spend money that's not on the budget without first renegotiating the budget.

My wife and I got into this habit almost 2 years ago.  Nowadays budget meetings take all of 5 minutes.  Paid off $48k between 401k loans, HELOC, credit cards, and student loans.  We've now got no debt, an emergency fund with 6 months of expenses, we're saving 15% of our income towards retirement, kids college savings in going, and we're giving a lot more money to worth causes than we ever thought possible.

[coppertales]

I have done this because lately, the stock market is not making me any money and the interest that I am paying in is more than I am making from the 401k investments.  I tailor my payments to pay the loan off in a year.  I did this to pay off unsecured credit because I wanted to take advantage of a zero interest credit card.  I was refused the credit card after I did this even though my credit rating is well into the 800 range. Go figure, the folks with low credit scores must really be up the creek......chris3

[Brad Johnson]

Bad Idea
Bad Idea
Bad Idea
Bad Idea
Bad Idea

Make min payments on the card until Sept when the car is paid.  It goes unsaid to not charge anything else to it.

After the car is paid, take the car payment and add to the min card payment.  Start killing the card balance.

Brad

[Balog]

Wouldn't it make more sense to pay off the card first?

[K Frame]

"I have done this because lately, the stock market is not making me any money and the interest that I am paying in is more than I am making from the 401k investments"

If that's the way you're looking at your 401k, you're looking at it the wrong way.

In the past I've always increased my 401K contributions in a falling market. Dollar cost averaging.

[Ben]

In the past I've always increased my 401K contributions in a falling market.

Big 10-4 to that.

[K Frame]

Yep.

Now it doesn't matter. A few years ago I pegged my contributions to max out by the last pay check in November.

Currently I've got 27% of my paycheck every two weeks coming right off the top and going into the 401K.

[Werewolf]

All of that advice from all those people and only two of you are right.

Guys - I make my living as a financial analyst and have for the past 13 years. I'm here to tell you that what the OP wants to do is absolutely the right thing - with two caveats (and not withstanding the psychological issues inherent in doing a 401K loan and the discipline required to make it work):

1) Do it only if you are relatively sure you'll be working for the same employer for the next two or three years or at least as long as you set up the loan payback period for. Why? Because if you end your employment prior to the loan being paid off you'll have to pay off that loan to your 401K within some set by law time limit (90 days I think) or pay the 10% income tax penalty on the amount of the loan still outstanding. In addition you can choose not to pay off the 401K loan at all and you'll have to pay the 10% income tax penalties (very common that - not paying off the 401K loan that is - which is why for many people 401k loans aren't all that great of an idea).

2) He must continue to make his regular contribution to his 401K. Don't stop it like so many do when they take out a 401K loan. The payback amount must be incremental to the regular contribution. A lot of people figure out how long it will take to pay the loan off if the payback is the same as their regular contribution. Then they stop their regular contribution while paying back the loand - smirking all the time at how smart they are because they get money out of their 401K they think for free. NOT! Bad idea to do that. It will cost you money in the long run because at the end of the payback period you're back to where you were prior to making the loan. You still earn interest and capital gains on what was there prior to the loan but for all practical purposes if the payback period is two years you've just lost two years worth of contributions and growth. OH! I'm pretty sure (slight chance I'm wrong unless the law's changed in the last 5 years or so) that the loan payback is not considered pre-income so you lose the tax benefit gained from the normal pre-income non-taxable normal contribution.

If 1 above is true then doing 2 is simply a method to refinance high interest debt with low interest debt (and the interest you're paying is actually to yourself and with today's market that 10% is probably more than the annual return on what ever his 401K is invested in). At the end of the payback period the OP would have more in his 401K than if he didn't make the loan (assuming whatever his 401K is invested in doesn't bomb and lose value that is).

I don't even have to break out my financial calculator or Excel to know the truth of 2.

When push comes to shove though the OP has to decide for himself what to do. He's either got the self discipline to make it work or he doesn't.

[Brett Bellmore]

And let me mention as somebody with an outstanding 401 k loan, who just got laid off after 23 years of steady employment and no complaints about my work, you don't really know you'll still have the job.

I've done it twice, the first time it worked out great, like Werewolf said, better rate of return than anything the rest of the money was invested in. This time, it's going to bite me on the ass if I don't find work fast.

[K Frame]

Hold on, I'm a bit confused...

Is the original poster intending to borrow FROM his 401K (an early disbursal), or AGAINST the value of the 401K?

Very very different scenarios.

The 401K may have significant restrictions on what loans can be made for and what types of loans are permitted.

And, you do end up paying tax on the money TWICE:

1. When you repay the loan, your payments are made with after tax dollars.

2. When you withdraw the money when you retire, you pay taxes on it, again.

[Werewolf]

Hold on, I'm a bit confused...

Is the original poster intending to borrow FROM his 401K (an early disbursal), or AGAINST the value of the 401K?

Very very different scenarios.

The 401K may have significant restrictions on what loans can be made for and what types of loans are permitted.

And, you do end up paying tax on the money TWICE:

1. When you repay the loan, your payments are made with after tax dollars.

2. When you withdraw the money when you retire, you pay taxes on it, again.

I believe the OP is talking about taking a regular loan against his 401K and not a disbursement for buying a home, medical emergency etc.

re:
1) True enough but those dollars would be pre-tax if he paid off his current high interest debt anyway. Wash

2) Tax rate when you retire is generally way lower than when you're actually earning a wage.

The OP's turning 20% debt into 10% debt as I understand it and that's a good deal providing the OP meets the caveats I noted in my post above.

[Balog]

Assuming the CC debt came as a result of lifestyle choices and not a sudden emergency, changing your lifestyle to be able to pay down your existing debt might be wise. Break the bad habits first rather than dig yourself in deeper.

[Green Lantern]

Break the bad habits first rather than dig yourself in deeper.

Oh yes, that is DEFINITELY on the agenda!  Though quite a bit of my debt came from unforeseen troubles, the rest was from irresponsible spending.

And to clear up any confusion:

I believe the OP is talking about taking a regular loan against his 401K and not a disbursement for buying a home, medical emergency etc.

Is right.

Now, I DO plan to be at the same job for the 2 or 3 years to pay off the loan - plus a LOT more.  'Course, as Brett said, that may not be how it works out.  Which is really what worries me the most.

As long as I've been in my 401-K, I've kept my contributions at 5%, loans or no - which is the maximum amount my employer will match.  Reducing or stopping my contributions was NEVER something I was considering.  In fact, after I had some savings amassed I was thinking about going above the 5% level.

[Werewolf]

Assuming the CC debt came as a result of lifestyle choices and not a sudden emergency, changing your lifestyle to be able to pay down your existing debt might be wise. Break the bad habits first rather than dig yourself in deeper.

How would the OP be digging himself in deeper???

He would be replacing 20% debt with 10% debt and paying his 401K back the principal along with interest that goes to his 401K and not the CC companies. In addition when he's done his 401K will actually be ahead of where it would have been if he hadn't taken the 401K loan since he will be continuing his normal contribution and growing it along with replacing the principal and adding the 10% interest he's paying to himself.

I agree that changing his spending habits re: credit cards is probably in order (pay them down to ZERO every month - don't charge more than you can afford to pay to get them down to zero each month). That said: by borrowing funds from his 401K he lowers the amount of interest he pays on the debt and what interest he does pay he pays essentially to himself.

Borrowing from his 401K is a win/win for the OP - if he meets the 2 criteria I set forth previously and it seems he is willing to do that.

[Tuco]

Don't do it.  Pay off your debts with money you make in your regular paycheck. 

Did (do you) contribute to your 401k as a discriminatory income savings account?
I thought not.  Cause that ain't what it is.  It's retirement savings.
Let it accrue.  Don't fiddle with it. 

After the car loan and credit card debt is paid, what will be the next obsession you need to feed?   Grampster said it best.  Change your habits to meet your obligations.

Leave the 401k alone.  That's money YOU paid to YOU.

[Desertdog]

Another thought; are you able to obtain a loan from some other source, such as credit union, home equity, family members,or lower percentage credit card?
Check your credit report and FICO score and see where you stand credit wise before you look for other lenders.

[Green Lantern]

I'd thought of that - like getting another CC with a lower interest rate and transferring the balance.

Thing is, I don't like having more lines of credit open than I HAVE to.  I've already had someone steal my CC number once somehow, and go on a shopping spree in a Best Buy on the other side of the country! 

Luckily, my CC company (Capital One) caught it fast and dealt with it - with no $$$$ out of my pocket for the unauthorized charges.

[Brad Johnson]

along with interest that goes to his 401K

The amount borrowed from the 401k earns no interest until repaid in full.

Brad