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Apr 25 2011 12:00AM

Question


I have about $14,000 in high interest credit card debt and $12,000-$17,000 available in a 401(k) to borrow at a low interest rate of less than five percent. All the interest paid goes back into my retirement savings as the loan is paid off. Should I take out such a loan to pay off the 15-30 percent interest rate debt?

Answer


“There are several factors you need to consider before taking a 401(k) loan,” said FPA member Dalia Wood, MA, CFP®, E.A. “One of the most important is that if you should be terminated for any reason, and you can't immediately repay the outstanding loan, it will be recharacterized as a withdrawal and be subject to income tax as well as early withdrawal penalties — you could end up owing more overall than you do now. Even if your job is extremely secure, you can't borrow more than 50 percent of your 401(k) balance. Also, the money that goes to pay off the loan is 'after-tax' money, so every dollar you pay towards the loan will cost you $1.30 or more — that's no longer a 'low' interest rate when you take that into consideration.” 

“I don't know what your current ability is to pay down the credit cards, or if the circumstances that got you into this debt have changed, but my strong recommendation would be to go over your expenditures and cut every non-critical expense and pay down the credit cards without touching your 401(k) balance,” said Wood.

“As always the answer is ‘it depends’ and one would have to look at your whole financial situation to really give the best answer,” said Mitchell Kraus, CFP®, CLU, ChFC, of Capital Intelligence Associates. “That being said, borrowing money from your 401(k) to pay off high interest rate cards probably does make sense.”

Kraus suggested you watch out for the following:

  1. How steady is your job? What are the rules if you were to leave on 401(k) loans? Most (but not all) employers require loans to be paid back immediately upon an employee leaving the company. If that happens, you’d need to come up with the money to pay the loan or risk owing taxes and penalties on the remainder balance of the loan.
  2. As with everyone who is in debt, the question is “How did you get there?” If it was a period of unemployment or emergency, using your 401(k) plan to pay it off makes sense. If you have been living outside your means, you need to make sure you have changed your budgetary habits to make sure you don’t end up with a 401(k) loan AND high interest credit card debt in a few years.

“If you are aware of the pitfalls, changing a high interest loan to a lower interest one where you are paying yourself interest makes a lot of sense,” said Kraus.

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