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Author: Mark0Young Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 25247  
Subject: Re: 401K loan to get rid of CC debt Date: 7/14/2001 1:21 PM
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Anyone feel strongly for or against taking loans out of your 401k to pay off cc debt?

Yes, I have strong feelings. I'll give you my reasons, but you must make your own decision. People's financial situations can be far more complicated than revealed in a simple message, and even though I am posting a message recommending that you do not take out a 401(k) loan, for some people it is the best fit for their specific financial situation.

I would recommend strong caution on taking out a 401(k) loan.

1. If the credit card debt is caused by living beyond one's means and the problem of deficit living hasn't been addressed, no amount of refinancing the debt will solve the problem, and the credit card debt will climb up again. For example, I found a report on the FDIC site that basically said that on one study of 6,000 home equity loan borrowers, only 30% were not back in credit card debt one year later. The report didn't address other types of loans but I wouldn't be at all surprised if they are equally failures on eliminating credit card debt. My advice? If you are going to get a loan to pay off credit cards, make sure you have a debt elimination plan in place first because otherwise the loan just becomes an enablier to get further into debt. (The "Consumer Credit / Credit Card" board has many participants that have taken out 401(k) loans or home equity loans to pay off their credit card debts before they were committed to debt elimination and ended up in more debt, and in most cases those people reported the loans turned out counterproductive. On the other hand, once they were committed and had plans in place, and often after taking scissors to their cards, a few people found such a loan is a good fit by allowing more of the same-sized payments to pay off the debt faster due to the lower interest rate or due to freeing up some cash flow to pay off other high-interest debt.)

2. Related to 1 is that many people feel a false sense of relief and become less zealous to guard against deficit spending.

3. Often such loans (401(k)/403(b) or home equity) have lower payments so people become lax about getting it paid off early so, even with lower interest rates, it isn't unusual to actually end up paying more dollars of interest to that debt because that debt is stretched out over a longer period of time.

4. Many 401(k) loans in particular do not allow for accelerated payments, so one has to pay the standard payment amount at least until one has enough money saved up to finally pay it off in full. Contrast that to CC balances and most home equity loans where, if one has extra money one can send in, the extra amount would reduce the principal and thus reduce the dollars each month going towards interest.

5. Many 401(k) plans allow only one loan at a time to be outstanding. So if you take out a 401(k) loan to pay the CC company, and a year later you have a sudden, big cash need (a tree is blown over and damages your roof, or your car needs an expensive repair so you can get to work), if your plan doesn't allow multiple outstanding loans, you would be stuck with having to get a loan from someplace else.

6. Most 401(k) plans require that a loan be paid back shortly after separation of service, typically 30 or 60 days after separation from service, or the outstanding loan balance would be considered an unqualified distribution, and thus the IRS would want 10% penalty on that balance plus the balance reported as ordinary income, and many states also would charge income tax and possibly their own penalties. So, to avoid a tax consequence that could approach half of the outstanding balance, you would have to find or borrow that money from someplace else, which may be near impossible or expensive if the cause of separation from service is being layed off or disabled. On the other hand, if one is anticipating separation from service to go to a better paying job, the 401(k) loan could be quite a deterrent.

There are some 401(k) plans that allow loan payments to continue after separation from service, so this is something you may want to check.

7. Money is taken out of the market for the 401(k) loan. It is called a loan, but actually the money is withdrawn from one's 401(k) investments, then as one pays back the loan the money goes back into the 401(k) investments. Generally, it is better to have stock market exposure for maximum potential growth, but the reality is that no one really knows what the market will do for the next few years, so one doesn't know if stock market exposure is best, or if paying yourself that 6.75% you would be paying yourself would be a better return on your money for the next few years.

If you haven't done so already, you might want to read the FAQ over on the "Consumer Credit / Credit Card" board.

As I said in my opening comments, I would generally discourage 401(k) loans to pay off consumer debt, but for some people it does end up being the best fit for their situation. What is really important is that you make an informed decision that fits your needs.
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