At a Glance
Carrying too much debt is a problem that can affect you in several other areas of life. At first glance, using funds from your 401(k) plan to pay off that debt may seem like a good idea, particularly if you have high-interest credit cards. It’s your money. Why not use it? That’s the question we’ll attempt to answer for you today. Here’s what we’ll cover:
Should you use a 401(k) loan to pay off debt?
There are a number of reasons you may consider borrowing from your 401(k), including to pay off debt. Whether you should use a 401(k) loan to pay off your debt depends on factors like:
- How much debt you have
- What type of debt it is (such as loans or credit cards)
- The interest rate on your current debt
- Your credit score
- Your employment situation
In some cases, it can make sense to use these funds to pay off high-interest debt, like credit cards. It’s best practice to first explore other options for debt repayment, but if those are ruled out, a 401(k) loan might be an acceptable choice. Using a 401(k) loan to pay off your high-interest debt can help save you money and help you pay off your debt faster.
A 401(k) loan may make sense if:
- You have poor credit, or don’t want your credit score to take a hit from a hard credit inquiry associated with other types of loans.
- You don’t want to complete a loan application or credit check.
- You want funds quickly, within a few days.
- You want no prepayment penalties.
- You can repay the loan within five years.
- You want flexibility with repayments, such as through payroll deductions.
- You want the opportunity to grow your retirement investments through “interest” on the loan.
How does a 401(k) loan work?
A 401(k) loan allows you to borrow money from your retirement savings and pay it back to yourself over time, plus interest. You can typically borrow up to 50% of your balance for up to five years, for a maximum of $50,000.
The interest rate is typically the current prime rate plus 1%. Once you sign the paperwork, you’ll have access to the funds within a few days. Then, the loan payments and the interest get paid back into your account.
Not every plan lets you do this, and how much you’re able to borrow, how often, and repayment terms are dependent on what your employer’s plan allows. The plan may also have rules on a maximum number of loans you may have outstanding on your plan. Note that if you leave your current job, you may have to repay the loan in full very quickly. Or, if you default, you’ll owe both taxes and a penalty if you’re under age 59 ½-years-old.
Factors to consider before getting a 401(k) loan
- Interest rates
- Risk of defaulting
- Retirement plan hit
Important to know
If you lose or leave your job during the loan term, payment is due immediately or else you will owe distribution taxes and maybe even an early withdrawal fee.
Pros and cons of borrowing from 401(k) to pay off debt
As we mentioned above, taking out a loan from your 401(k) plan is essentially borrowing your own money. You won’t need to go through an approval process with a lender to borrow the money. If you set up online access, there’s likely an option on the website to do this quickly and conveniently. That’s both good and bad, but we’ll keep it in the “pro” category.
- Flexible Repayment Options: Fund administrators want you to pay back your 401(k) loan quickly and painlessly, so they offer flexible repayment options. There are no early repayment fees, and you can set up direct debits to ensure you don’t miss a payment.
- Low or Non-Existent Lending Costs: You may be charged a small origination fee and there might be an administrative charge, but 401(k) loans are the lowest cost lending vehicle you’ll find. If you must borrow to pay off debt, this is likely the best option.
- Neutral Impact on Retirement: A common misconception is that borrowing from your 401(k) will have a negative impact on your retirement fund. That only happens if you do it during a bull market. Otherwise, the impact is neutral because you pay the money back with interest. We’ll get into this in more detail below.
On the other hand, there are also some reasons you may not want to use your 401(k) to pay off debt. For example, when the stock market is consistently rising it’s known as a “bull market.” That means the funds in your 401(k) plan are increasing in value. Taking them out while that is happening could cost you those potential gains. This is the most common argument against 401(k) loans, but it only affects you when the market is bullish.
Legitimate “cons” include the following:
- Risk of Job Loss: As we all learned in 2020, no job is guaranteed to be secure. If you lose your job while you still owe money on a 401(k) loan, the IRS requires you to pay off the remaining balance within sixty days. Failing to do that will reclassify the loan as an early withdrawal and you’ll be subject to a 10% fee and income taxes.
- The S&P 500 is Up 20% This Year: The timing for a 401(k) loan should be carefully considered. The S&P 500 is up 20% this year, so taking funds from your retirement account is probably not the best option. A personal loan, despite the higher interest rate, would be more cost-effective.
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Reasons to borrow from your 401(k)
The top reasons to borrow from your 401(k) loan include:
- It’s fast and convenient, especially since there are no lengthy applications or credit checks required. You’ll then get access to the funds within a few days.
- There’s repayment flexibility, including being able to repay the loan faster with no prepayment penalty. Some plans even allow payments to be made through payroll deductions.
- There is technically no cost to take out a 401(k) loan for short-term needs. When you specify the investment account from which you want to borrow money, those investments are liquidated for the duration of the loan. So, you won’t lose any positive earnings that would have been produced by those investments. There is a cost advantage equivalent to the interest rate charged on a comparable consumer loan minus any lost investment earnings on the principal you borrowed.
- The loan repayments go back into your account’s investments, and you even repay the account a bit more through “interest.”
Like personal loans, you can use 401(k) funds for several things including:
- Household bills and expenses
- A down payment for a house
- Consolidating debt
- Medical expenses
- Home repairs
- Education expenses
- Moving expenses
Alternatives to 401(k) loans
When considering your financial situation and needs, a 401(k) loan may be an option. However, there are other alternatives that should be considered as well. The top two include balance transfer credit cards and personal loans.
1. Balance transfer credit cards
You can use a balance transfer credit card to move an existing high-interest credit card balance to a lower-interest card. Doing this will help save you money on interest, especially because many balance transfer cards come with no annual fee and a 0% introductory APR, meaning you don’t have to pay interest for a certain period. Transferring your balance will not only save you money, but it can also help you pay off your credit card debt faster.
The downside is these cards sometimes come with balance transfer fees, transfer limits, and credit score requirements, so a poor credit score may mean you have trouble getting approved. Plus, you should be sure to repay the balance before the intro period is up or face higher interest rates on the outstanding balance.
Learn more: Balance Transfer Credit Cards
2. Personal loans
Personal loans are a type of loan you can borrow from a bank, credit union, or online lender. Loan funds can be used for just about any reason, making them a good option for well-qualified borrowers who need financing. Terms and interest rates vary based on lender, your credit score and history, and other factors, but borrowers with good to excellent credit typically qualify for lower interest rates.
These loans are usually unsecured, meaning they don’t have to be backed by collateral, and have fixed terms and rates, so you can quickly and easily calculate your monthly payments, how much the loan will cost over time, and when you’ll have it paid off.
Compare: Best Personal Loans
401(k) loan myths and facts
Myth: Borrowing from your 401(k) will impede the performance of your portfolio.
Fact: Because you repay the funds back into your account, the long-term effect on your 401(k) will be minimal. These investment accounts will have ups and downs over time anyway, so the impact of short-term loans will depend more on the current stock market environment. The actual impact should be neutral, or even positive.
Myth: 401(k) loans are tax inefficient.
Fact: You put pretax dollars into your 401(k0, and 401(k) loans are repaid with after-tax dollars. However, that doesn’t mean you’ll owe taxes on that money again when you take it out during retirement. Only the interest portion of the repayment is subject to that treatment. However, this is only meaningful if a large amount is borrowed and then repaid over multiple years. Even in that case, it typically has a lower cost than alternatives.
Myth: You should never borrow from your 401(k).
Fact: Many experts say you should avoid a 401(k) loan at all costs. However, these loans can be better than some alternatives, such as payday loans, carrying a balance on a credit card, or even a home equity loan. When the loan comes out of your investment account, you’re repaying it plus interest back into that account over a shorter period, so it won’t have as negative of an impact.
Myth: Taking out a 401(k) loan is too risky in the event I quit or lose my job.
Fact: If you quit or lose your job, you’ll have a set period to repay the loan. This period is usually short, up to 60 days. However, in the event you’ve lost your job and are having difficulty repaying it, you may be able to work with your plan on alternatives. Additionally, in the worst-case scenario, the unpaid loan amount is subject to a 10% early distribution penalty and income tax. While this isn’t ideal, you won’t risk losing assets or having an impact on your credit score.
Overall, using a 401(k) loan to consolidate your credit card debt is a huge risk. If you’ve exhausted all other options, you might consider it. However, you risk paying unnecessary taxes and fees should you default, and you sacrifice your retirement savings and peace of mind in the process. Plus, 401(k) loans do not help you stay out of debt because they don’t address the reason you may be in debt in the first place.
No, there’s no credit check to qualify for a 401(k) loan, and credit reporting agencies don’t use your retirement savings as a variable when they calculate your credit score.
In most circumstances, a 401(k) loan will not affect your tax return. If you lose your job and can’t repay the loan, the IRS may reclassify it as an early withdrawal and tax you on it.
It’s your money. No one will charge you a fee to borrow it, as long as you pay it back.
No. In most cases, it’s a good idea to take a 401(k) loan to pay off debt because it’s the lowest-cost lending option you’ll find, and you can typically use it to pay off debt fast. Just don’t do it during a bull market or if you think you’ll lose your job soon.
Most plans have a borrowing limit of $50,000 or 50% of the account funds, whichever is less. Plans also typically have a limit on how many loans you can take out at one time.
Though 401(k) loans can come with lower interest rates and no credit checks, they put you at a high risk of paying unnecessary taxes and penalties, not to mention cutting into your retirement savings. Learn about other debt consolidation methods.
If you need the money fast for a short-term expense and can pay back the loan on time, borrowing from your 401(k) is fine. It can be especially effective for your retirement savings if you take out the loan while the stock market is weak. We would not recommend a 401(k) loan for debt consolidation, though.