- Interest rates on a 401(k) loan can be more appealing than some other debt consolidation options.
- If you lose your job, however, you may be at risk of defaulting on your 401(k) loan.
- Taking money out of your retirement, even for a few years, can also set you back on your savings progress.
Dealing with credit card and other high-interest debt can be challenging, so it's natural to look for any possible way to relieve some of the pressure on your budget and financial health.
Borrowing from a 401(k) to pay off debt can seem like a good way to achieve your goal. Interest rates are relatively low, and the interest you pay goes back into your retirement account. But there are some significant risks that 401(k) loans carry that can ultimately cost you more in the long run.
Understanding how 401(k) loans work can help you determine whether or not using one for debt consolidation is the right move for you.
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How do 401(k) loans work?
A 401(k) is an employer-sponsored retirement plan, and when you take out a loan from your 401(k) plan, you're essentially borrowing money from yourself. As a result, there's no lender and no credit check when you apply.
That said, there are some key rules for 401(k) loans that you should know about:
You can borrow up to the greater of $10,000 or 50% of your account balance, with a maximum of $50,000.
Interest rates can vary, but they're generally just one or two percentage points above the prime rate, which was 4.75% as of July 14, 2022.[1,3]
Plan sponsors may charge an origination fee and a loan service fee, which adds to your cost.
Repayment terms max out at five years unless you use the loan funds to purchase a home.
If you leave your company or get laid off, your plan sponsor may require you to pay back the loan by the filing date of your tax return for that year.
If you don't pay off the loan in full, the unpaid portion will be treated as a distribution from your account, which may incur a 10% penalty and income taxes.
According to a National Bureau of Economic Research report, only 10% of 401(k) loan borrowers default, but that figure skyrockets to 86% for those who leave their companies (because of a change in employment) with an outstanding loan.
Pros and cons of borrowing from a 401(k) to pay off debt
As with any debt consolidation choice, there are both benefits and drawbacks to using a 401(k) loan. Here's what you should consider.
- No credit check: If your credit is in bad shape and traditional debt consolidation options are off the table, a 401(k) loan can be your most affordable option.
- Low interest rates: You may be able to score a lower interest rate on a 401(k) loan than a personal loan, even if you have a solid credit history.
- You're borrowing from yourself: All of the principal and interest that you pay on your loan go back into your account for your use in the future—though the plan sponsor keeps the upfront fees.
- Easy repayment: Your payments will typically be taken from your paycheck, so you don't have to worry about setting up automatic payments from your bank account.
- Won't increase your debt-to-income ratio: If your debt-to-income ratio (DTI) is a concern—maybe you're planning on buying a home in the near future—a 401(k) loan doesn't show up on your credit report, so there's no impact to your DTI.[7,1]
- You may not have the option: Not all employers offer 401(k) plans that allow loans, and if you have a 401(k) plan that's tied to a previous employer, it's likely not an option, even if they offer it.[4,8]
- You may not have enough: Depending on how much debt you're looking to pay off, your 401(k) balance may not be large enough to cover the full amount.
- You'll lose out on potential gains: Any money you take out of a 401(k) account in the form of a loan is no longer earning gains, along with the rest of your account. "That’s not such a bad proposition if markets perform poorly over the loan period," says John Shrewsbury, a financial advisor and co-owner of GenWealth Financial Advisors. "But it could be costly if you miss a big upswing in your investments."
- It's costly if you leave your employer: If you find a new job or get laid off, you'll need to pay off your remaining balance more quickly than you originally planned. If you can't, you may incur taxes and a penalty, which can make your 401(k) loan costlier. Additionally, with a repayment term of up to five years, a 401(k) loan you can't pay back immediately may leave you feeling stuck with your current employer.
- Interest is taxed twice: The interest you pay goes back into your account, but you're paying it with after-tax dollars, says Shrewsbury, and when you withdraw that money in retirement, it'll be taxed again unless you have a Roth 401(k) plan.
Can you borrow from an individual retirement account?
Individual retirement accounts (IRAs) do not allow you to borrow money in the form of a loan. However, you can take an early withdrawal from your account to pay off debt, just as you can with your 401(k) plan.
That said, the consequences of an early withdrawal before you reach the age of 59½ can vary depending on your retirement plan[9-13]:
|Plan type||Contributions||Taxes and 10% penalty|
|Traditional IRA||Pre-tax||Full amount|
|Nondeductible traditional IRA*||Post-tax||Only the gains portion|
|Traditional 401(k)||Pre-tax||Full amount|
|Roth IRA||Post-tax||Only the gains portion|
|Roth 401(k)||Post-tax||Only the gains portion|
*You may have a nondeductible traditional IRA if your income is too high to qualify for the regular contribution deductions.
Borrowing alternatives to consider
A 401(k) loan may be on the table, but there's a risk of it ultimately costing you more in the long run.
"Letting the loan default builds a bigger financial burden at tax time when you have to pay the taxes and penalties that come due after the default," says Shrewsbury. And even if you do pay it back on time, you may miss out on potential gains that can compound over time.
Depending on your situation, there may be other potential options to consider as you work to pay off your debt. Here are some to compare:
If you have good credit: A balance transfer credit card can give you several months to pay off your credit card debt interest-free. Alternatively, you can opt for a personal loan to consolidate your debt if you prefer to have a structured repayment plan.
If your credit is less than stellar: You may start by trying to negotiate a lower interest rate, a forbearance plan or a modified repayment plan with your creditors. Alternatively, you can consult with a credit counseling agency to determine if a debt management plan is right for you.
If you own your home: You may be able to take advantage of the low interest rates on a home equity loan or home equity line of credit. However, your eligibility is limited based on how much equity you have, and default could result in you losing your home.
If you're behind on payments already: If you're behind on your payments and your credit score has already taken a hit, you may consider asking your lender or the debt collection agency to settle for less than what you owe. That said, you may need to pay the settlement amount in a lump sum. Consider consulting with a debt attorney or debt settlement firm first.
If you have no other options: If your financial situation is in disarray and you don't have any other options, you may consider filing for bankruptcy as a last resort. Before you do so, consult with a credit counselor and a bankruptcy attorney.
There's no single best way to tackle your debt, so it's important to research all of your options and pick the one that best fits your situation and goals.