Avoid 401(k) loan to pay credit card debt

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Dear Debt Adviser,
I am considering taking out a loan from my 401(k) of about one half of my account, or $22,000, at a 5.25 percent interest rate with a 60-month payback period. I’d like to do this to pay off some high-interest credit card debt at 19.99 percent and 24.99 percent, respectively. This would pay off both of these cards with balances of $7,600 and $13,600.

I always make payments on time and pay more than the minimum, but the banks have refused to lower the interest rates and we just received notice that they also just lowered all limits. Thanks for any advice you can provide!
— Betty

Dear Betty,
I can understand your desire to ditch your high-interest credit card debt. I’m just not sure if it is worth jeopardizing your retirement to do so. Let’s take a look and you can decide what you believe would be best.

Other than the fact that you will lose the compounded earning potential of the $22,000 you remove from your 401(k), which is nothing to sneeze at, the biggest gamble you take borrowing from your retirement is losing your job before the loan is fully repaid. Should you get laid off or need to change jobs, the balance of the loan would become due immediately. If you were unable to repay the loan, the balance would be treated as a premature distribution and you would have to pay a penalty of 10 percent as well as federal and state income taxes at a time when your only income might be unemployment, which is often taxable as well.

In addition, the loan interest is not tax deductible as it would be for a home equity loan. Your 401(k) contributions are made before taxes are deducted, but your 401(k) loan payment does not come with the same benefit. You would be repaying the loan back with your income after taxes have been withheld.

This means you will repay the 5.25 percent loan rate plus 28 percent, or whatever your current income tax rate is, to use your own money. As an example, your payment each month to repay your loan in 60 months would be $417 a month if it was a simple 401(k) contribution. Without the benefit of the pretax status, you’ll pay $533. The difference amounts to taxes you pay that you would not have to pay if it was your regular pretax 401(k) contribution.

You may want to consider a home equity loan if you are a homeowner and if the housing prices have stabilized in your neighborhood. If you can qualify for an interest rate that’s competitive with your 401(k) loan, you would have a tax advantage because the interest on the home equity loan is deductible. An additional plus is your retirement money stays intact and earning interest. The downside of an equity loan is you are exchanging unsecured credit card debt for secured debt. That could place your home in jeopardy if you were to become unable to make payments as agreed.

You said, “We just received notice that they also just lowered all limits.” So there are at least two of you whose limits have been lowered. You might consider transferring the balances to cards with lower rates, taking out a passbook or a signature loan at your bank or credit union, or just making some cuts in your budget to apply more money to paying down your balance. With more than one of you pulling in the same direction, this will be easier than doing it by yourself.

If you do decide to go through with the 401(k) loan, I encourage you to increase your payments to $661 per month and pay off the loan in 36 months rather than 60. The same applies to any other method of repayment you choose. This will limit your window of exposure to life’s unexpected surprises that always seem to appear when you are at your most vulnerable!

Good luck!

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