Should You Use a 401(k) Loan to Pay Off Your Credit Cards?

401(k), Paying Off Debt, Personal Finance
Should You Use a 401(k) Loan to Pay Off Your Credit Cards?

Not all 401(k) plans have a loan provision, but if yours does, you might wonder whether you should take advantage of it to pay off your credit card debt. Borrowing from your retirement to pay off consumer debt is a hotly debated topic, so you should hear both sides before you make your decision.

Think twice before taking out a 401(k) loan

Your 401(k) is a retirement account, and it serves you best in that capacity. But you can save a lot in interest by using a 401(k) loan to pay off credit card debt, Harvard Business School professor and behavioral economist John Beshears says.

In an email interview with the Nerds, Beshears explains that with some credit card interest rates as high as 30%, “you will pay a much lower interest rate on the loan, and better yet, you will be paying interest to yourself because both principal and interest payments on 401(k) loans go into your 401(k) account.” But before you borrow from your retirement, consider the drawbacks:

Opportunity cost: Andy Prescott, a CPA in Manhattan, Kansas, used a 401(k) loan for a down payment on his house to avoid having to pay private mortgage insurance. He didn’t consider, however, what he’d miss out on. “I took my loan out in 2012 and had it for three years,” Prescott says. “As it turns out, that was a huge three years for the stock market.” When he compares what he would have earned had he left the cash in his 401(k) to what he saved in private mortgage payments, he acknowledges, “I lost out big time.”

Beshears agrees with this sentiment, but also urges those in credit card debt to consider that “paying down credit card debt is like earning a guaranteed return equal to your credit card interest rate, while keeping money in a 401(k) earns a much lower average return that is subject to risk.” Depending on your outstanding credit card balances and interest rates, you may benefit from consolidating your debts with a 401(k) loan. But before making the decision, consider whether the opportunity cost is worth it.

Tied to your company: If you quit or lose your job, you typically have to repay your 401(k) loan in full soon thereafter, regardless of the original loan terms. If you’re unable to pay by the deadline, the loan is treated as an early withdrawal and is taxed at your current income tax level, in addition to a 10% penalty.

When Prescott originally took out his loan, he wasn’t planning on making a career change. But three years later, his feelings changed and he made the difficult decision to switch jobs with $16,000 left on the loan. To make matters worse, he needed to make some emergency repairs on his roof to the tune of $7,000. Not knowing where he would come up with $23,000 on the spot, he ended up going into credit card debt. Prescott is in his late 30s now and believes credit card debt should be behind him: “It hurt to have to borrow from my credit card like that.”

Even if you’re not planning on switching employers, you may still want to consider that your perspective or factors outside your control may change over time. A career shift could put you right back where you started, or worse.

Nerd note: A 401(k) loan — or any other debt consolidation product — won’t change your spending behaviors. If you feel that paying off your balance may tempt you to max it out again, seek credit counseling.

» MORE: How to pay off debt

Alternatives for paying your credit card debt

In most cases, a 401(k) loan should be a last resort to pay off your credit card debt. Here are a few less risky options to consider:

Personal loan: Depending on how high your credit card interest rates are, you may be able to find a personal loan with a lower interest rate. But like a 401(k) loan, you have a limited amount of time to pay off your balance. If you think you would be at risk of not being able to make the monthly payments, it may be better to pay more in interest than to have your credit damaged by a delinquency.

0% balance transfer card: Credit card issuers offer an introductory 0% APR on balance transfers for a limited time on some of their cards. Some 0% APR periods can be almost two years long, giving you time to take a serious swing at your debt without interest. However, many 0% balance transfer cards require excellent credit and have a balance transfer fee, which is typically 3% of the balance transferred. Before applying for a card, make sure the amount you save in interest is greater than the upfront balance transfer fee.

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Home equity line of credit (HELOC): If you’re a homeowner and have equity in your home, you can use a HELOC with your home equity as collateral. You’re likely to get a better rate than with your credit cards because you have collateral, and the interest you pay is tax deductible. However, you should proceed with extreme caution if you plan on using this option. If you default, you risk losing your home.

Have a plan

Although Beshears believes that using a 401(k) loan is a good way to pay off high-interest credit card debt, Prescott wouldn’t recommend it unless you’re out of options.

Regardless of how you choose to pay off your credit card debt, the most important thing is to take the time to create a plan to pay it off as quickly as possible. Consider how much of your budget you can direct toward debt payoff and when you intend to have it paid off. Then review the pros and cons of each option and find which one fits your plan.

Ben Luthi is a staff writer covering personal finance for NerdWallet. Follow him on Twitter @benluthi and on Google+.

Image via iStock.