photo © 2007 Eric | more info (via: Wylio) A reader sent in this question from the contact form:
I was wondering what your take is on borrowing from a 401K to pay off credit cards. Everything I’ve read says not to but 1) I have an interest rate on one card that is 27%; 2) I’d be paying myself back an annual rate higher than anything I’m getting now. So why not?
What is a 401(k) Loan
Most anyone with a 401(k) account has the ability to “borrow” funds from their retirement. The IRS allows you to withdraw money from a tax deferred 401(k) to use as you wish with the stipulation that you pay it all back within a certain time period to avoid tax penalties.
In general, it is a horrible idea to take money out of a 401(k) until you are retired. This is mostly a psychology issue, not a financial issue. I am in the mindset that my 401(k) funds do not exist. I don’t have access to them until I retire. Period.
For many 401(k) borrowers, it is easier to skip paying it back and take the tax hit, which is often a lower dollar amount than paying the fund back. If you are borrowing because you are short on money and you have creditors after you, are your habits really going to change enough that you honestly think you are going to pay it back?
The Finances of the Situation
Mechanically, it is probably a better decision to take out the money to pay off the 27% credit card. If you would really pay yourself back at the rate your were paying the credit card companies, taking the money out is a slam dunk. However, there are other alternatives than a 401(k) loan that you might consider.
Alternatives
The first thing I would do is call the bank and ask for a lower rate. It is often that simple.
If I could not get a lower rate, I would look around for balance transfer opportunities. Do you have other credit cards that would let you do a balance transfer? If you will save more than the transfer fee by moving to the lower rate, go for it.
If you are a homeowner, you can take out a “second mortgage,” which would be secured to your home and offer a much, much lower interest rate. However, if you don’t pay that loan your home is at risk.
If you have never looked into social lending (also called Peer to Peer Lending), you might be surprised with a good deal from sites like Lending Club or Prosper. Depending on your credit score, you might be able to get a great rate compared to the credit card.
Conclusion
While it might seem like a good idea to borrow from your future, it should be considered a last resort. Consider your other options first.
I am sure other readers have good ideas too, so please chime in and leave your opinion in the comments.
Eric,
If you tell the reader to head over to nerdwallet.com they have a lot of great credit card deals. I was there just last night and I think that citi is offering a 12 month 0% interest balance transfer. That would be much better than taking a 401k loan.
Great idea Jeff.
My recent post The Case for Walmart
A 401k loan is usually not a good idea. But in the event that you need to do it, here is a good article that describes the step-by-step: http://tinyurl.com/39h2sbh
Good info Ben. Lets just hope it doesn't come to that.
My recent post The Case for Walmart
Well, if you have bad habits towards re-payment, it’s a bad idea to take out *any* new loan.
But for me, a 401K loan is a viable option when purchasing hard assets, like a car or a home. And the interest paid back on the loan is paid back to oneself.
Thanks for the thoughts. I lean toward the same idea as you.