When It Makes Sense to Borrow From Your 401(k)

You should do other things first, but sometimes a 401(k) loan is a valid way to pay down high-interest credit card debt

a1050093324 Photo Illustration: Lacey Browne/Consumer Reports, Getty Images

Tapping your retirement plan to pay off high-interest debt sounds tempting, especially with interest rates on the rise. Then there’s the added satisfaction of paying the interest on a 401(k) loan back to yourself, not the bank.

But there’s a whole host of reasons why you shouldn’t touch that money. Perhaps the biggest right now is that you’re taking money out of the stock market after a major sell-off. 

“Chances are your account is down right now, so you’re locking in a loss,” says Lauren Lindsay, a certified financial planner (CFP) based in Houston. 

That’s why financial professionals recommend you explore other options before raiding your 401(k).

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“First I’d be hammering on the expenses and seeing if there’s anything that can be done to get some cash to throw toward the credit card,” says Jim Holtzman, a wealth advisor based in Pittsburgh.

Among the strategies Holzman recommends: Call your credit card company and ask for a lower rate. Negotiate with the utilities to get a break for a period of time. Seek a credit counseling agency to negotiate with creditors. Shop at less expensive supermarkets, if you can.

“Those aren’t fun processes to go through but you’re really trying to lower that burden,” he says.

There are times, however, when a 401(k) loan makes sense.

“If I’m looking at a situation where the credit card debt is so high, the monthly payment is so high, and it’s just gonna be interest compounding on interest, not knocking the principal down, that would certainly change my reflection,” says Holtzman.

One of the biggest benefits of a 401(k) is compounding interest. Over time it can generate a lot of wealth. But if your high-interest credit card debt is costing you more than what your 401(k) will ever earn, that’s a serious problem, Holtzman says.

When seeking a 401(k) loan, it’s not an all-or-nothing, one-size-fits-all strategy, says Stephanie Genkin, a fee-only CFP based in Brooklyn, New York. 

“You shouldn’t say, ‘let me just grab that $20,000 from my 401(k).’ Instead, see where you can get small pots of money that equal into this,” she says. “It’s not meant to be your piggy bank.” 

“I had a young client who had slipped into some credit card debt, and we created a multi-layered plan where we were going to knock that debt out—all in one month in her case—but we didn’t resource from only one place,” she says. “We only took a $5,000 loan from her 401(k) when it was at its height.” She and her client also sold some stock options that had vested from her company because the stock had done very well. On top of that, they also tapped into savings.

Here are some of the benefits of 401(k) loans:

  • You can usually take up to 50 percent of your 401(k) balance, up to $50,000, out of the plan and use it without incurring any taxes or penalties, as long as you pay the loan back in time.
  • You pay the interest on the loan back to yourself instead of paying it to a bank, or to the 401(k) provider.
  • You normally get up to five years to repay this type of loan, and repayments are made automatically with each payroll cycle.
  • Applying for a loan isn’t going to impact your credit score.
  • Origination fees and interest rates for these loans tend to be small. “Typically, you find plans have tied their rate to prime plus 1 or 2 percent—today that’s 4.75 percent plus 1 or 2 percent,” says Jarrod Sandra, a CFP based in Crowley, Texas.
  • Plans tend to limit the number of loans that can be outstanding or taken in a year, reducing borrowers temptation to overuse the tool. “The rules vary depending on the plan, so before you do anything, it’s important to connect with your provider to confirm what applies to your specific product,” says Sandra.

Still, the downside of 401(k) loans is considerable.

“Taking a loan from your 401(k) can go terribly wrong,” says Jason Siperstein, a CFP based in Rhode Island.

Here are some of the dangers you need to be aware of:

  • If you change jobs—or even worse, lose your job—you’ll have to pay the remaining balance immediately. “An outstanding 401(k) could make changing jobs very expensive!” says Herman Thompson, an Atlanta-based CFP. “This means you may only have a short window (usually 60 days) to completely repay the outstanding loan. Any amount you don’t repay becomes subject to income tax and (if you’re under 59.5 years old) a 10 percent penalty. Ouch!”
  • A 401(k) loan can’t be discharged in bankruptcy. “If you can’t pay back the loan, it’s seen as a withdrawal,” says Steve Wilson, founder of Bankdash, a personal finance site dedicated to improving consumer understanding about banks.
  • Your future investments and retirement plans may be hurt. “The money you borrow won’t be available to work for you if the market recovers,” says Justin Stevens, a Rochester-based CFP. “This could be more costly than the interest charges on the credit cards over five years,” he says.
  • Borrowing now is like buying stocks high and selling them low, says Lindsay, the Houston-based CFP.
  • You may get double taxed. “Yes, the loan comes out with no taxes, but the payments go in after taxes. Then when the money is taken out down the road, it will be taxed again,” says Kyle Newell a CFP based in Winter Garden, Fla.

Image of Octavio Blanco, editor at CR with Money CIA

Octavio Blanco

My mission: To write stories that broaden readers' horizons and offer new solutions they can apply to their lives. Who I write for: My family, my friends, my neighbors, myself, and—most important—you. My passions: Music, art, coffee, cheese, good TV, and riding my electric bike (for now). Find me on Twitter: @octavionyc