Take out a 401(k) loan to pay off debt

[ThriftyMan]

Like reducing retirement contributions to pay off debt, this topic excites opinions from all directions. We think that if you can control your spending and not just rack up more debt, tapping into your 401(k) can be a good source of low-interest funds to apply to debt. However, if your employee matches contributions and you can pay off your debt within 3 years, you should continue to contribute the minimum possible to max out the employer match.

We've written a blog post on how you can think about tapping into your 401(k) to pay off debt here.

Share your thoughts with others by submitting a post. Even if you disagree (and odds are good that you might) we'd love to hear your thoughts.

[KristinH]

I think this could be a BAD idea right now. So many 401K plans are depressed already because of the economy, taking a loan at this point, then gives you a debt that is losing even MORE money. Plus, with pink slips flying, what happens to your 401K if you don't pay back the loan and you lose your job? If I remember right from my last job with a 401K, you have to pay up w/in a short period or lose those matching funds. Besides, borrowing money to pay debt doesn't really reduce debt just rearranges the seats on the proverbial sinking ship.

[soulsa]

I think taking a loan from your 401(k) is a bad idea too. Your loan repayments are from "after-tax" dollars so you already got taxed, then when you retire, those after tax dollars get taxed again. The best idea is to start using cash so you don't contribute to additional debt, then change your spending habits (do you REALLY need it?). It's a difficult journey but not an impossible one!

[maskay]

Another consideration with a 401(k) loan is that if the worst were to happen, such as file for bankruptcy, your 401(k) is protected. However, if you have taken the money out to try and pay off credit cards you later discharge in bankruptcy then it was a waste, as you still have to pay back your 401(k) loan.

[ThriftyMan]

Maskay

Good summary on the risks of the 401(k) loan. I looked at the stats for this at one time and I think about 25% of people with a 401(k) have taken a loan against it. I think for the reasons you mention, this is probably really high. It can be a userful tool, but you need to know that your job is secure, your income is secure, and that you have no danger of going into bankruptcy, and that you plan to be with your job for at least the next 4-5 years while you pay off the loan. That's a pretty high hurdle. Again, a useful tool, but in very limited circumstances.

One thing I saw when I was in banking is that we (borrowers) tend to pay off credit card debt with loans like a home equity loan of a 401(k) loan and then blow the credit card debt back up, increasing the overall debt and putting bankruptcy-protected assets at risk. nearly 80% of people who take out a home equity loan do this. So although these sound like good strategies, often our behavior makes them risky.