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Should You Take Out a 401(k) Loan to Pay Off Debt?

By Katie Brockman – Updated Jan 22, 2018 at 9:05AM

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Or is it smarter to save your retirement funds for retirement?

Debt comes in many forms, and the average U.S. household that carries debt owes around $131,431 in total, according to NerdWallet's 2017 household debt study. The bulk of that comes in the form of mortgages, but Americans also carry an average of $15,654 in credit card debt, $46,597 in student loans, and $27,669 in car loans.

If you're working hard at saving for retirement (which you should be!), it can be tough to balance saving for your retirement goals and paying down debt. Some people choose to take out a 401(k) loan to relieve themselves of debt, thinking that once the debt is paid off, they'll be able to boost their retirement contributions, avoid paying interest on outstanding debt, and ultimately save more in the long run.

Person buried under a pile of bills holding help sign

Image source: Getty Images.

Are you ready to drain your 401(k) and knock out that mortgage now? Not so fast. Borrowing from your 401(k) is a big decision, and there are several factors you need to consider.

1. Perform a financial checkup

Before you even think about taking out a 401(k) loan, see if you can find extra cash elsewhere to put toward debt. Ideally, you should be contributing to your 401(k) and paying down debt -- not one or the other -- so if you can reduce your spending somewhere else to make that happen, that's the best option.

For example, if you're struggling to keep up with credit card payments and are thinking about pulling money from your retirement fund, take a look at where that credit card debt is coming from. Is every expense truly necessary, or could you cut back in a few places? If you skip this step and jump straight to using your 401(k) savings to pay down debt, you're not fixing the root of the problem and will likely run into the same issue again later down the road.

For other types of debt, you may not be able to control how much you're paying each month, but you can map out where all your money is going and try to find places to cut back. If you don't already have a monthly budget, now is the time to make one. You may discover that you're spending hundreds of dollars per month eating out at restaurants, for instance, and by cutting back on those expenses, you can put more money toward paying down debt.

2. Examine your interest rates

If your disposable income is already stretched thin and you can't find any wiggle room, the next thing to consider before taking a 401(k) loan is the various interest rates you're paying.

Not all debt is created equal, and some forms are more harmful to your overall financial health than others. Credit cards, for example, have notoriously high interest rates, averaging an APR of 15.59%. Compare that to mortgages, with an average annual interest rate of 3.86% for a 30-year fixed-rate mortgage, and student loans, with annual interest rates typically ranging from around 4% to 7%.

Before borrowing from your 401(k), crunch some numbers to determine how long it will take you to pay off your debt at the rate you're going and how much interest you'll have paid during that time. With a 401(k) loan, the interest you'll pay is typically the prime rate plus 1%. So if the prime rate is 4.5%, you'll pay 5.5% annual interest. Knowing this number is beneficial as you weigh your options, as a lower interest rate could ultimately save you thousands of dollars. Or, in the case of mortgages and student loans, for instance, you could actually end up paying more in interest by taking out a 401(k) loan.

It's typically wise to take out a loan only to pay off high-interest debt that's racking up thousands of dollars in interest. For example, if you owe $10,000 in credit card debt with a 16% APR, and you're making minimum payments of $35 per month, you'll end up paying around $4,759 in interest alone over about ten years -- and the more you fall behind, the more you'll end up paying in interest. 

Keep in mind, though, that a 401(k) loan is still a loan, even though it's your own money. Although your payments go back into your own account, you will have to keep up with the interest as well, and you're typically required to pay back the loan within five years.

3. Consider your entire financial picture

Deciding whether to take out a 401(k) loan is not easy, and it's important to look at the big picture. For example, are you planning on leaving your job in the near future? Most employers require that you pay back your 401(k) loan within 90 days if you leave the company, otherwise you'll owe taxes on it and may be subject to an additional 10% penalty fee if you're under age 59 1/2.

Also be sure to research all your other options before making a decision, because borrowing from your 401(k) should be a last resort. If you're struggling with credit card debt, for instance, but you have a good credit history, you may be able to transfer your balance to a balance transfer credit card with a 0% APR introductory period. Or you may qualify for a debt consolidation loan to pay down your debts without pulling money from your 401(k).

One of the most important things to consider, though, is how a 401(k) loan will impact your retirement savings in the long run. Some 401(k) plans don't allow you to make additional contributions until your loan is paid back, so you're essentially pressing pause on your retirement savings for five years -- which can significantly impact your financial goals.

Say, for instance, you're borrowing $10,000 from your 401(k) with a 5% annual interest rate and plan to pay it back within five years. Let's also say you're not making any additional contributions and that you could have been earning a 7% annual return on your investments had you not taken a loan. Over that five-year period, you're potentially missing out on returns of around $2,000. 

In addition, one of the greatest perks of contributing to a 401(k) is that you're contributing pre-tax dollars. However, repayments are not pre-tax, meaning you're not only missing out on potential gains while you're repaying your loan, but you're also shelling out more money in taxes.

Taking a 401(k) loan should be a last resort to tackle debt, but it is a possibility if you've exhausted all your other options. If you decide it is the best option for you, focus on paying it back as quickly as possible and getting back on track with your regular 401(k) contributions immediately to avoid doing too much damage to your long-term retirement savings.

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