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Carla Fried: A 401(k) loan to pay off credit cards is super messy

Carla Fried, Rate.com on

Published in Home and Consumer News

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: https://www.rate.com/research/news/advantage-young-compound-growth

--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.

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