Should you borrow from your 401(k) to pay off credit card debt?

The decision to use a 401(k) loan to retire high interest credit card debt is not as obvious as it may seem.

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A reader sent me an email recently seeking advice on paying off a private consolidation loan with a 401(k) loan. The 401(k) loan would cut his payments from $350 per month to $150, with a significantly lower interest rate. Great, right?

On the contrary. There's a lot of math and psychology involved in a decision like this. Here's my take on it.

The math
This reader, let's call him Bond, is carrying about $8,000 on the consolidation loan, which has a 16.5% interest rate. The 401(k) loan has a 4.5% interest rate. That's a significant difference, but don't be (small-f) fooled. Let's compare the payoff period for these 2 loans:

  Consolidation Loan 401(k) Loan
Amount outstanding $8,000 $8,000
Payment amount $350 $150
Interest rate 16.5% 4.5%
Number of payments required 28 60
Interest paid $1,670 $943

As is, the consolidation loan will be paid off in a little over 2 years, with a total interest charge of $1,670. On the other hand, the 401(k) loan will take 5 years to pay. Bond will save about $700 on interest, but he'll also be paying off the loan for 5 years instead of 2.

Psychologically and from a risk standpoint, this is a huge difference. Most 401(k) loans are generous with repayment while you remain employed by your company. However, if you decide to leave your job, or are involuntarily removed from it, the loan almost always becomes payable in full right away. Some people stay in the same job for years on end and have almost total employment security—many people don't.

To me, this is the kind of risk that shouldn't be taken lightly. Not only that, but staying in debt for 5 years might feel a little demoralizing over the long run if the alternative is to get out in a little over 2. While this is a personal preference issue, for me, the latter would be far more palatable.

Another option
Provided the 401(k) loan is pre-payable, there is of course a third option: take the loan, and pay it as though paying the consolidation loan.

  Pre-Paid 401(k) Loan
Amount outstanding $8,000
Payment amount $350
Interest rate 4.5%
Number of payments required 24
Interest paid $380

From a mathematical perspective, now you're talking. This version of the loan will be paid off in 24 payments with only $380 in interest charges. In this situation, Bond will have saved himself almost $1,300 in interest, and very effectively reduced the employment risk he's facing.

How to decide what to do
So, is it worth it? I still don't think this is a no-brainer. The decision to take a 401(k) loan in this situation should ultimately rest on 3 factors:

1. The employment risk. This is something everyone faces, but in differing degrees. Because it's difficult to gauge accurately, making a guess on this front is anything but trivial.

2. The contingency plan. If the worst happens, and the job is lost, how will the loan be repaid? This is probably the most important question because it also addresses another critical area: the availability of alternatives. Bond is probably considering the 401(k) because of either a lack of other options, or a perception that those options aren't very good alternatives. If there isn't an alternative now, what will happen if he loses his job?

I wouldn't advise a contingency plan based on an early 401(k) withdrawal. Assuming Bond faces the normal penalties associated with this, the fees and taxes could amount to up to $2,800, assuming a 25% tax rate, a 10% penalty, and a need to withdraw the full amount of the loan. That's a lot of money, and far worse than a 16% interest rate. Not only that, but it would bring the double whammy of paying too much and robbing Bond of retirement savings—and the growth they could have enjoyed by being left alone.

3. Psychology. I am very big on debt psychology—not only because I love the subject, but because I've experienced it myself firsthand. I know how badly things can go when optimism meets denial.

The 401(k) loan only really makes sense, in my mind, if Bond can commit to making a $350 payment, and is as close to certain as he can be that he'll remain with his employer for the next 2 years.

Once you start to tinker with this fairly strict set of conditions—paying a little less here and there, hoping that you'll still want to stay at the job in another few years, or just giving up and making only the minimum payment—it is very easy to get into trouble.

I obviously don't know what else underlies this particular situation, but I can imagine the 401(k) loan is attractive precisely because of its lower payment. I can completely understand that, and also the attraction of an interest rate savings over time.

However, neither one of these comes for free. They come with risk and a leash.

My answer: Find another way
My answer to this question would be to see if there aren't any better options out there. If the current payments are too high, perhaps there's another way to refinance this loan at a lower interest rate that doesn't hinge on staying in the same job. It's also worth calling the loan provider to find out whether it can help restructure the deal to make the payments more manageable.

Similarly, maybe there's a way to find savings somewhere else in the budget—either by reprioritizing spending, or by finding new sources of income. These are not trivial matters, and finding savings with either method can take a significant amount of effort and sacrifice, but that doesn't mean they aren't worth it.

In the end, answers to financial questions are not solvable by math alone. Depending on the personal dynamics involved, this particular one might be an easy "yes," or it might be a risky "no." To play it safe, both against job loss and human behavior, I would try to find a different approach. To me, financing the past with the future is a gamble best avoided.

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Article copyright 5/9/2015 by The Motley Fool.
The statements and opinions expressed in this article are those of the author. Neither Fidelity Investments nor your employer can guarantee the accuracy or completeness of any statements or data.
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