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Financial Planning / Foolish 401(k)s


Subject:  Re: Loan from 401k to pay off cc debt Date:  10/21/2001  12:17 AM
Author:  Mark0Young Number:  13442 of 26342

Need some input here on the pros and cons of taking a loan from my 401 to pay off credit card debt?


1. Possibly lower interest rate.

2. No credit check (usually).

3. Probably not reported to a credit reporting agency because when you "borrow" you are actually taking your own money out of the 401(k) temporarily.

4. This could be considered a "bond" portion of your 401(k) investment because most (but often not all) of the interest you pay actually goes back into the 401(k) as additional money towards investments, which right now is better than most investments one can make in a 401(k). (BUT see Con:2.)


1. The biggest problem is that these methods of eliminating credit card debt is that they tend to be a temporary solution. For example, a year ago I used a Google search to find on the FDIC web site a report stating that 70% of those taking out home equity loans are back in credit card debt a year later. The credit card industry calls it "reloading". I haven't seen similar references in 401(k) circles, but it wouldn't surprise me if "reloading" CCs is common for 401(k) borrowers. (If one is going to use a 401(k) loan or a home equity loan to "pay off" the credit cards, one should be committed to a debt elimination plan, including paying off the new location of those debts. Without firm commitment, such loans just become an enablier to get into worse debt.)

2. The money is actually withdrawn from your 401(k) so that part of your money isn't exposed to market gains (or market losses) until that part of your loan is repaid. (Bull markets can sneak up unexpectedly.)

3. If you become separated from service, most 401(k) plans (but not all of them) require that the current balance of the loan be repaid quickly, usually 30 or 60 days, or the current outstanding balance would be deemed an unqualified distribution (requiring income tax and 10% penalty be paid on that balance, plus any state income tax and state penalty).

4. A number of 401(k) plans allow only one loan to be outstanding at a time. So if one has a 401(k) with that restriction and already has a loan outstanding, if a second loan is needed (e.g., to repair the roof that a tree just fell into), one would be stuck.

5. Likewise, a number of 401(k) loans will allow either the contracted monthly payments (payroll deduction after taxes, usually), or payment in full, but nothing inbetween. (The rationale given is to keep costs down.)

6. Even though the 401(k) loan may have a lower rate than the credit cards (it depends on how the credit card issuers perceive how risky it is to loan to you), you may end up paying more dollars of interest due to the length of the loan than if one just concentrated on paying off the higher-rate credit cards. Part of this is because people perceive 18% to 24% credit cards to be much more evil than 10% 401(k) loans and thus work to get those credit cards paid off as quickly as possible, but feel a false sense of relief once the balance is moved off of the credit cards.

The 401(k) loan is paid back with after-tax money, so one doesn't get a tax break for a 401(k) loan as opposed to a more conventional loan of the same interest rate. This isn't necessarily a "con" but rather pointing out something that some people might not be aware of so one doesn't assume yet another advantage that really doesn't exist.

In the "Consumer Credit / Credit Card" bard a few people have reported that a 401(k) loan or a Home Equity Loan had helped them in their debt elimination plan and turned out to be the perfect course of action for them, but most of the reports of using such loans is that they wished they had never taken out those loans (which just became enabliers for getting into further debt). The difference seems to be to have a debt elimination plan in place and to take steps to prevent reloading of the credit cards.

My take? It is a tool, can be a dangerous tool, and far from a panacea. Consider it, but also consider the potential down sides before taking this course of action.

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