Hi All, I am new to this Foolish world and am looking for advice.By some coincidence, the amount of my credit card debt roughly equals the amount I can borrow from my 401k.My credit cards are at about 7%, my wife is good at getting the low interest rates as they come by. The 401k loan interest rate is about 6%. Of course the interest will go to me.I have heard that this may be a bad idea since I will be losing out on the wonderful stock market gains I could make on that loan amount. But then if one is feeling bearish...What do the Fools recommend in this situation? The credit card debt is high enough to preclude me from building a cash reserve or do some serious investing.Any insight is welcome!Thanks in advanceSteve
Hey, snash!While many may disagree with me on this point, I'm not a believer in borrowing from a 401K to pay off cc debt. The 401K, being a retirement account is too precious an asset for the future, and too often unforseen circumstances come around that could cause one to put off making payments to repay the loan. I know of too many people who have borrowed from their 401K's and just never paid back the loan.There really isn't much of a difference between what your interest rate is on the cards and what your loan interest would be, so I just don't see that as much of an issue. I'd keep the 401K nice and safe, and wouldn't even mess with it. Instead, I'd just pay off the cc balance as quickly as possible to get rid of it. Tony...but I still am...Off2Aruba
Tony,The 401k is certainly a precious asset! My first reaction to your post was that "but I WILL pay off the loan". But then I think about getting downsized out or something and then I could end up in the position of not being able to pay off the loan. I guess I need to see what happens if I am unable to repay the loan on schedule. At least with the CCs I can drop back to minumum payments if something unexpected arises.As far as the interest rate goes, since the 6% is being paid to ME rather than to the CC company, doesn't that tilt the balance in favor of taking out the loan?Steve
<<But then I think about getting downsized out or something and then I could end up in the position of not being able to pay off the loan.>> Steve,This is what I was thinking too. If unforeseen events caused you to not repay the loan, that's an awful lot of compounding on money you don't get to realize later on. Sometimes we fall into the trap of thinking, "Well, it's just 'me' I'm not paying back, so it's no big deal." Later on, it turns out to have become a big deal after all. I'm one who would consider borrowing on a 401K, only if there's no other alternative, ie emergencies, etc.<<As far as the interest rate goes, since the 6% is being paid to ME rather than to the CC company, doesn't that tilt the balance in favor of taking out the loan?>>While it's a good way to justify things, what's really the difference on where the money is being paid back. Check with your 401K and see if the money acts as if it's still in there, as long as it's being paid back. I don't think that's the case actually.I belong to the NYS Teachers' Retirement System, and can take very generous loans at like 1% over prime (or aprox.). In my case, it's easy as the loan is taken directly out of my check, and as long as the payments are being made, the money is still accruing as if no loan was outstanding. Now, with 401K's, as I understand it, only the money that's not out in loan is compounding, hence, you've got less in the account, plus you're paying 6% interest.But even if you were getting the same benefit that I have with the TRS, unless you could guarantee that there wasn't even the most remote chance that you wouldn't repay it, I'd stay away from that--unless you just had no choice. Instead, I'd look into some kind of debt consolidation loan if you had a lot of outstanding credit card debt, but I'd be surprised if you could really do better than the 7% you were paying.Bottom line, I just don't see any benefit to the argument that you're paying 'yourself' back as opposed to a cc company.Just my thoughts,Tony...but I still am...Off2Aruba
< I guess I need to see what happens if I am unable to repay the loan on schedule. At least with the CCs I can drop back to minumum payments if something unexpected arises.>If your participant loan becomes in default, presumably due to you no longer working at the company (most plans require direct payroll deduction of payments), is that it will become what is known as a distributable event. What that means to you is that you will pay tax on the remaining loan balance including a 10% penalty on top of your normal tax rate if you are under 59 1/2 years old.As for what will cause the loan to be in default, ask for your plan's "Loan Policies and Guidlines" from your employer. These can be included with the "Summary Plan Description," so you might want to ask for both. This should spell out what happens in the case that you stop making payments, etc. Even if you are terminated, most plans allow you to pay off the loan in entirety in some fixed period of time to avoid the distributable event. This means that even if you choose to pay off your cc's with a 401(k) loan and then are downsized later you could simply transfer the debt back to cc's if left no choice. Yikes, I cringe at the thought. I would hope you never have to resort to that.Good Luck!
< Check with your 401K and see if the money acts as if it's still in there, as long as it's being paid back. I don't think that's the case actually.>Absolutly! Loans in 401(k)s are generally just treated as an investment option, i.e. you are investing in you. It would be impossible for a plan to give you investment earnings on $10,000 on investment A when the money has actually been paid out to you as participant loan. As a matter of fact most record keepers in the industry will show your loan being cashed out of your investment funds and being transfered to a line item called participant loan. Then as you make payments they will show on your participant statement as part of the asset "participant loan" being transfered back to your actual investments.Since you are going to be replacing actual market investments with paying interest to yourself, you should compare the actual return you have been getting in the plan versus what you will actually pay in cc interest. Then assuming that you will be able to avoid a taxable event, see my other post, taking a participant loan would be sort of equivalent to moving your money to a money market with an interest rate approx. equal to what you would have paid in cc interest.
A 401-k loan is just a loan. But it's also an investment option. You need to evaluate it from both angles.1 - It's a loan. It's paid back with after-tax dollars, just like any other loan. The interest is NOT tax-deductible, just like any other consumer loan (a home-equity loan may have tax-deductible interest.) The advantages are: No qualifying required. Payments are typically through payroll deduction. Usually a lower rate than other unsecured notes.2 - It's an investment. It earns a fixed interest rate - relatively risk-free. (how good a credit risk are you?) As long as it's paid back, the tax status is unchanged. I.e. Principle and interest are tax-deferred.3 - It has sime risk. If you leave the company, it generally becomes due and payable immediately. If you don't pay it back, lump-sum, within something like 30 days, it's treated as a distribution. You become liable for income taxes and a 10% penalty on the outstanding balance. You could, I suppose take an advance on a credit card, and you'd be back where you started.So the questions to ask yourself are: 1) If I leave the company, will I be given a chance to pay the money back, so it's doesn't become a taxable distribution? and 2) Can I earn more in another investment than I am saving in interest?
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