The good news is that the interest payments are going into your retirement account and not to the credit card company. The downside is that the original contributions to the account were made with pretax dollars, but the loan payments will be made with after-tax dollars.
Below is a hypothetical situation to show the savings associated with using the 401(k) loan at 8 percent, compared with paying off a credit card balance at 17 percent.
You can put together your own table by using Bankrate's loan payment calculator to calculate the monthly payments. Use the savings calculator to determine the value of the loan payments reinvested over the next five years vs. how the account would grow if you didn't withdraw money to pay off your credit cards.
401(k) loan vs. credit card repayment comparison
|Monthly loan payment||($506.91)||($621.31)|
|Total payments (monthly payment
x 60 months)
|Interest expense (Total
payments -- loan amount)
|401(k) loan payments reinvested @
10% APR for 5 years
|$25,000 remains in 401(k) earning
10% APR for 5 years
In this case it makes sense to borrow from the 401(k). You've saved almost $7,000 in interest expense and you've freed up $115 in your monthly budget that you could use to pay back the loan faster. Put in your own numbers to make the worksheet relevant to you.
DangersAs a general rule, you should avoid raiding your 401(k) except as a last resort. Think of a 401(k) account as a safe haven rather than an emergency fund. The pitfalls to borrowing are plentiful. They include:
- Some companies charge fees, including $200 to $400 application fees. And, unlike 401(k) contributions, loan repayments are yanked from paychecks after taxes, not before. The loan is taxed again at retirement when it is withdrawn with the rest of the money in the account.
- The more money borrowed from a 401(k) account, the less the investment can grow. Things get worse if you try to avoid double deductions from your paycheck by stopping regular 401(k) contributions while you're repaying the loan.
- Your job must be very secure. A person with an outstanding 401(k) loan who leaves or is laid off better be prepared to pay up -- fast. Most plans require the loan to be paid within 30 to 90 days.
- If the loan is not repaid, it is considered a default and the outstanding loan balance is treated like an early withdrawal. It is taxed as ordinary income, and a 10 percent penalty is collected if the borrower is under the age of 59 ½.
- You may take this as an opportunity to run up your credit card balances again. This will leave you in a worse financial situation than before.
Putting money aside for the future requires that you spend less than you make. If you're not doing that, you need to get to the point where you are. If you're spending like there's no tomorrow, then don't be surprised if tomorrow comes and you don't have any money to spend.
Lucy Lazarony, Steve Bucci and Amy Fleitas contributed to this story.