I am considering borrowing money from my 401K to pay for some home repairs, and also to pay off all of my credit card debt. Is this a smart move?
-STEVE in Michigan
It is typically a bad idea to borrow from your 401k. There are situations where you could consider this option, like short-term needs and emergencies where you’re certain that you can put the money back into your account. But if this money is going toward a long-term need, then it’s probably more detrimental to your future. Depending on the nature of your home repair, this may or may not be a viable option.
As far as your credit card debt, you should not use your retirement money to repay that debt. An emergency home repair is one thing, but adding the credit card debt on top of that is just unnecessary. You’re much better off leaving that money in your 401k for the future, and continuing to pay down the credit card debt by other means. Without knowing more specific details about your finances and the state of your home, it’s tough to give an appropriate answer. To help as best we can, let’s go over some of the facts and potential pitfalls of borrowing from your 401k.
Important facts about borrowing from your 401k
- You can borrow up to 50% of the account balance, with a maximum of $50,000.
- The balance must be repaid in 5 years or less (unless you use the money to purchase a residence).
- There is no credit check, so you will receive a competitive interest rate regardless of your credit score.
- Payments are typically made through deductions from your paycheck.
- If you stop working for your employer while the loan is still outstanding, the full amount will become due in 60 days. If you’re unable to repay in that time, the loan will be considered a distribution (or withdrawal) and taxes and penalties will be applied.
Why not borrow from your 401k?
- Loss of earnings. The interest rate on a 401k loan will usually be less than a bank loan, but you have to remember that you’re also losing earned interest by removing money from your account. Remember this if you’re considering using the money to repay credit card debt. The interest rate of the 401k loan will more favorable than the credit card debt, but the lost earnings on your depleted account may outweigh that benefit.
- Some plans do not allow you to contribute to your 401k as long as the loan is outstanding. That’s more lost earnings.
- Double taxation. You’re paying back the borrowed amount with after-tax dollars, then you’ll pay the tax again when you withdraw the funds from the account.
According to a 2014 Ameriprise Financial Report, younger generations (those further from retirement) are more likely to borrow from their 401k. The report states that 17% on Millennials have done so, compared to 13% of Generation X, and 10% of Baby Boomers. This isn’t surprising, as younger people are more tolerant to this sort of risk because they have more time to rebuild their retirement savings.
Be sure you examine other options like borrowing from family or a home equity loan before considering borrowing from your 401k.
Anyone else looking for answers to their financial questions? Feel free to Ask Talking Cents Guy!
If you’re struggling with credit card debt and could use some more personal help, contact the certified staff at American Consumer Credit Counseling. Call 800-769-3571 for a free counseling session, or visit ConsumerCredit.com for more information on getting out of debt.