The Dangers of Paying Off Debt With a 401(k) Loan

If you are in debt, there are many aspects of paying off that debt with a 401(k) loan that are very alluring. For instance, you will likely receive a very low interest rate on your loan, around 4.25%, and a lower interest rate means a lower monthly payment. The fact that you can borrow any amount (less than a quarter of your balance or $50,000) as long as you have money in your account does not help dissuade many borrowers.  Despite these two facts, there are other factors that make this a poor choice to manage your debt. For instance, if you take out a 401(k) loan and decide to switch jobs (or are laid off), your employer will likely require you to repay the loan within sixty days. If you do not meet that deadline, the outstanding balance will be considered a distribution on which you will owe tax, and if you are under fifty-five a ten percent penalty will be tacked on as well. Additionally, some plans do not allow you to contribute to your 401(k) while a loan is outstanding, which results in two things. First, you will end up with a lower account balance at retirement, and second, since you will not been making contributions, your taxable income amount will increase, thus meaning you will pay more taxes.

A better alternative with nearly as attractive rates as a 401(k) loan many be a home equity line of credit. Interest rates for these loans depend on your credit score, the size of the loan, and the eagerness of the bank to lend, but the average rate is 4.8-5.13%. In addition to comparable rates, home equity lines of credit also boast advantages including tax deductible interest and more flexible repayment terms.  Other alternatives include transferring your debt to a zero percent interest card and paying off the debt amount before this period expires or getting a debt consolidation loan.

I implore you to consider the other options above, especially if you have an instable income, but if you still wish to take out a 401(k) loan, be sure you have a best and a worst case scenario in place to pay off the loan. Also, consider setting up an automated saving system and repayment plan, and make sure you understand your particular company’s charges, interest rates, and repayment rules.


Sources:

“Borrowing From Your 401K? Hardship Withdrawal Considerations.” thesmarterwallet.com. 17 May
2010. Web. 7–29 2012. <http://thesmarterwallet.com/2010/borrowing-from-401k-hardship-withdrawal/>.
Palmer, Kimberly. “Why 401(k) Loans Can Be a Smart Move.” U.S. News & World Report LP, 25 Jan.
2011. Web. 7–29 2012. <http://money.usnews.com/money/blogs/alpha-consumer/2011/01/25/why-401k-loans-can-be-a-smart-move>.
Updegrave, Walter. “Paying Off Debt with a 401(k) Loan.” Money Magazine: Ask the Expert. 6 May
2010.Web. 7–29 2012. <http://money.cnn.com/2010/05/06/pf/expert/401k_debt.moneymag
/index.htm>.
Wendy Clay

Wendy Clay

Wendy Clay is a Virginia Community College System graduate and a current undergraduate at the University of North Carolina. She is pursuing a degree in public health with a minor in exercise and sports science and plans to attend medical school upon the completion of her degree. She has diligently served those around her for many years as a tutor for rural school children and as an advocate in the fight against hunger in her community and around the world.

At The University of North Carolina Wendy plans to actively participate in a student group, Health Focus, which will enable her to use her knowledge and love for health and nutrition to educate youth in the Chapel Hill/Carrboro area. She also hopes to promote voter registration amongst her fellow students.
Wendy Clay