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Is It Worth Using a 401k Loan to Pay off Debt?
March 13, 2020

Is It Worth Using a 401k Loan to Pay off Debt?

Today, Americans have become even more immersed in debt. According to the Federal Reserve, total household debt balances increased by $601 billion in 2019 and exceeded $14 trillion. The last time such a huge growth happened 13 years ago, in 2007. People borrow more money to buy a house or automobile, cover tuition fees, or merely improve their lifestyle by using credit cards.

The possibility of receiving the necessary sum of money, whenever you need it, is thrilling. However, many people may fail to think about how they are going to repay the debt.

It’s financially healthy to rely on a stable income while planning monthly installments. Since many fail to do so, they have to look for alternative options. Paying off debt with 401k resources can become a reasonable solution in some cases.
Is It Worth Using a 401k Loan to Pay off Debt?

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What Is a 401k Loan?

To understand what a 401k loan is, it’s better to get your head around the term “401k”. 401k is a company-sponsored retirement plan. The employer assigns a certain amount of money from the employee’s salary for a long-term investment that is saved for retirement.

Usually, the money is invested in financial instruments like stocks, bonds, or other market accounts. It’s vital to remember that there is a contribution limit – a sum of payment which can’t be exceeded. It’s been increased in 2020 and amounts to $19,500.

Taking a 401k loan, basically, means cashing in retirement to pay off debt. Therefore, it’s not the best solution if you don’t have any additional savings for this period of life. The constantly increasing cost of living, in addition to the questionable stability of Social Security, it’s a crucial factor to consider before borrowing against the 401k.

Borrowing from 401k to pay a debt isn’t as simple as it may seem. There are several things to consider:

  • Legal Loan Limits: You are allowed to borrow as much as 50% of the vested balance, which mustn’t exceed $50,000. Keep in mind that not all employers allow any withdrawal of money before retirement.
  • Interest Rate: Although you are borrowing financial resources from personal funds, a particular price has to be paid. The good news is that you are the one who will receive it. The interest rate depends on your personal plan. Usually, it’s calculated according to the set formula like “Prime rate + 1%”.
  • Repayment terms: They are pretty similar to traditional borrowing. You make quarterly or monthly installments. Commonly, the maximum repayment term is five years. Please, note that your debt repayment is deducted from your paycheck after taxes.

Losing a job doesn’t grant you freedom from paying the debt. This may even worsen the situation. If the loan is outstanding, you may need to “return” the money quickly. If you fail to cover the obligations, the IRS will submit the remaining debt sum for a tax deduction in the following financial year. This is applied only to those who are under the age of 59½.

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The Pros and Cons of the 401k Loan

The idea to cash in 401k to pay off debt is a matter that requires a reasonable approach. People like it as it’s a quick solution to get extra cash. However, a failure to replenish deposits may drastically influence your financial situation after retirement. It’s better to avoid withdrawing large sums and to check into other alternatives before making the decision. Nonetheless, a 401k loan has its undeniable advantages:

Quick and Convenient Option

Borrowing money from creditors implies plenty of applications, a long waiting time, an interview, etc. It takes a lot of time and effort in the end. If you need some cash right now, a 401k is a good alternative. Don’t forget to check whether it’s allowed to sign up for such a loan or not.

Normally, all you have to do is visit a certain website and make a few clicks. The check will be delivered after a couple of days. With the development of digital banking, a small loan can even be instantly obtained via a debit card.

Lucrative Interest Rate

The interest rate is the second reason to use this type of obligation. As you are a lender and a borrower, the interest rate doesn’t really matter because you are contributing to your own good. Its purpose here is to slightly cover the lost finance.

Although it’s a more lucrative borrowing alternative compared to banks or any other creditors, you must keep in mind that the real loss is the potential gains. Once you cash in, this money isn’t generating income from financial instruments. It can be a good idea in case of possible investment loss.

No Impact on a Credit History

The 401k loan doesn’t affect your credit history. At the same time, it usually doesn’t request credit history information that can significantly influence the decision-making process. Therefore, it can be an ideal option to repay some small debts for those who failed to maintain a good credit score.

Repayment Flexibility

The permitted repayment term is five years. It’s a rather long period of time for small borrowings. This automatically means that most of the debtors are able to cover the obligation before the due date. The ultimate advantage is that you can repay the entire amount without a prepayment penalty.

Even though the 401k loan sounds appealing, the main disadvantage is that you steal the money that’s supposed to provide you with living after retirement. The opportunity to get financial resources without paying them back may drastically change during your senior years. It doesn’t mean that you are going to stay without money at all. But their amount can be significantly decreased.

When you cash in the retirement fund, it means cutting some part of the investment. It’s hard to predict the exact lost amount on your own. There is a Vanguard’s Retirement Plan Loan Calculator that can determine the amount for you. It can compare the 401k loan to other credit options, as well as calculate the amount of finances lost.

Another drawback is that the borrowed sum of money is limited. In case you’re wondering, “If I pay off my 401k loan, can I get another one?”, check the amount of the existing one. You can’t exceed more than $50,000 per year (if it accounts for 50% of the vested account). However, not all employers allow you to take several loans at the same time.

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Minimize the Risks

It’s hardly a reasonable approach to always wonder: “When can I use my 401k before retirement?” It’s much better to prioritize keeping the fund safe in order to ensure worry-free senior years. According to the Fidelity Investment calculations, the average 401k balance amounted to a bit more than $100,000 at the end of the second quarter of the previous year. However, there was an increase in those who’ve hit a $1 million benchmark.

It would be really depressing to lose a considerable amount of money. Even if using 401k to pay off mortgage seems like a reasonable solution, keep a cool head. Here are several points to consider:

  1. Don’t apply for a 401k loan if you are constantly in debt. The easy, fast money is tempting, especially if you can’t manage the income/spending issue well.
  2. Plan the monthly installments so that your regular, stable income can cover it. This way, you will minimize the risk of not being able to keep up with the payments.
  3. Avoid increasing the debit. For example, if you took a 401k loan to pay off credit card debt, stop going over the limit. Otherwise, you’re going to use up precious resources and increase your obligations. Therefore, you aren’t reducing the overall debt balance.

Should I Stop Contributing to My 401k to Pay off a Debt?

There are different approaches to debt management in the case of a 401k loan. To understand what’s more beneficial: stop contributing to the retirement plan and repay the debt or allocate money to both – you must assess each situation in particular. In case you don’t have sufficient financial knowledge, our consultants can assist you. They will also help to determine whether you are allowed to keep contributing to the retirement plan. Sometimes, it’s prohibited.

Basically, it’s not compulsory to stop contributions to the 401k account while borrowing from it. It’s a so-called guarantee of a higher output at the end. This is especially relevant when the loan interest rate is low, and the 401k ROI – Return on Investment – is high. On the other hand, if the interest rate is rather high, hurling all effort into financial freedom is reasonable. This may save more money as; basically, you borrow money from your resources.

Consider Other Options

One of the key aspects to keep in mind about repaying debts is that there are other options. You aren’t required to stick with the first one. It may not be the best solution in terms of financial benefits. Here are some common alternatives.

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Debt Settlement

Debt settlement implies negotiating the repayment amount of money or interest rate with creditors. It’s not always an easy and fast way. One of the standard techniques is to persuade the borrower that you are on the verge of bankruptcy. The fear of losing all of the money may stimulate him to provide more favorable terms.

Bankruptcy

It’s a good solution as you don’t have to pay anything once the application for bankruptcy is completed. However, if your obligation is secured by collateral, you are going to sacrifice it. Also, it’s vital to remember that bankruptcy drastically decreases the credit score and remains for about a decade.

Debt Consolidation

Debt consolidation is a situation when you receive a loan that covers all the existing debts. It usually comes at a lower interest rate; therefore, it’s more lucrative in terms of financing. Your credit score plays an important role here. The higher it is, the better borrowing terms you can count on.

To Sum Up

There are plenty of debt repayment solutions that can be considered. It’s better to evaluate all of them before making a final decision. Although competence may be a problem, professional consultation is the right solution. Experienced DebtQuest USA specialists are going to assess your particular situation and find the best solution.

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