A 401(k) Loan to Pay Off Credit Cards Is Super Messy
Here’s a better plan for the long term
No matter how low interest rates are in many parts of our financial lives — a 30-year fixed rate mortgage was 3.2% in late June, federal undergraduate student loans for the upcoming academic year have a fixed rate of 2.75% — we know the rate charged on unpaid credit card balances to be insanely expensive: The average is nearly 17% these days.
So yes, it’s a worthy goal to get a balance paid off ASAP. But as with everything in life, it’s important to consider the consequences of how you pull that off.
According to the latest annual survey from the Transamerica Center for Retirement Studies, among people who took a loan from their 401(k), more than one in four used the money to pay off credit card debt.
The appeal is obvious. A 401(k) loan doesn’t require jumping through any qualifying hoops.The interest rate is low. According to Vanguard’s 2020 report on the plans it administers, most charge either the prime rate, or one percentage point above prime. Right now, the prime rate is 3.25%.
Moreover, through late September, it’s possible to borrow even more from your retirement account. The CARES stimulus bill passed by Congress allows participants in plans that allow loans to borrow the full value of their account, up to a maximum of $100,000.
Borrowing at 3.25% to 4.25% to get out of debt costing you at least four times as much makes a lot of sense. And if your household has run into some financial stress during the coronavirus crisis, tapping your retirement savings may seem like a lifesaver. But it comes at a cost, and the bottom line is that it should only be considered after you’ve exhausted all other alternatives.
Consequences to consider.
The opportunity cost of your money not growing for retirement. Money you pull out is no longer able to compound for your retirement. And some plans don’t allow you to continue to make contributions to your account while you have a loan. That can be an even more serious drag on your long-term success. Let’s say you’re 35 years old and you contribute $250 every two weeks ($6,000 a year). If you suspend your payments for two years, that’s $12,000 in saving that you didn’t do. If you had saved the $12,000 it would be worth more than $50,000 after 30 years assuming a 5% annualized return. Sure, you can hustle to catch up, but given how hard retirement saving is, you need to be honest if you will ever have the mojo to amp up your savings to make up for the lost time when you had borrowed money. Check out my column on the benefits of compounding for younger adults.
It gets messy fast if you lose your job (or take a new one). According to Vanguard, just one in three plans allows terminated employees who have a loan to keep repaying it. Everyone else is required to repay the loan in a few months. Which typically is not great timing if you’ve just been laid off.
If you don’t repay the loan, it will be treated as a withdrawal. If you’re younger than 55, there’s a 10% early withdrawal penalty, and if the money was in a traditional 401(k), every dollar will be taxed as ordinary income.
Are you really solving a problem? One of the most important questions to ask yourself is why you have the big unpaid credit card bill. Was it because you had a big unexpected series of health insurance co-pays? That’s a one-off event that is essential spending.
But is your credit card balance a function of just spending too much, period? On wants vs. needs? If that’s your issue, a loan likely isn’t going to solve anything. Until you figure out a way to rein in spending, you’re likely to just run up another credit card tab. Using your retirement money to gloss over your lifestyle or budgeting disconnect is just compounding your problems. Here’s some advice on reversing lifestyle creep in the COVID age.
Clearly, just because you can take out a loan, doesn’t mean you should. And the easy nature of accessing your money can make it seem preferable to doing the harder stuff. Like getting serious about finding a way to spend less so you can send in an extra $100, $200 or more with each month’s credit card payment. A quick web search for “credit card repayment calculator” will land you at free tools that will show you how fast you can repay your debt based on whatever your budget is.
And if you happen to have credit card debt and a great credit score, you really should consider a balance transfer deal. Granted, in this coronavirus recession, it’s likely not as easy to qualify for a great deal, but there are offers still being marketed that will give you a year or more of zero interest on any balance you move to the new card issuer. If you had that year (or more) with no interest, might you be able to put a large dent into the balance?
Longer term, a way to avoid the temptation to take out a 401(k) loan is to build in a cash cushion so you don’t need to put emergency expenses on a credit card.
Granted, for younger adults this can seem like a way-too-big ask. Indeed, while millennials with a workplace retirement plan are doing a pretty solid job of contributing, they aren’t doing as well with the emergency savings fund. Transamerica says millennials had a median of $3,000 set aside in an emergency fund.
If you honestly can find a way to juggle both retirement and emergency savings, it can make sense to temporarily scale back what you’re saving for retirement. But only if you use the money that’s not going into retirement to build up your emergency fund. You can learn about emergency fund building here.
There are two hugely important rules to considering this. First, commit to only doing this for a short period. Maybe give yourself six months to a year to build up your emergency fund by reducing your retirement savings. The second key rule is to make sure you continue to contribute enough to your 401(k) to earn the maximum employer match. There is no scenario where it ever makes sense to miss out on that free bonus.