Is a 401(k) Loan a Good Idea?

Paying high-interest credit card debt, month after month, is both irritating and costly.

So at first blush it seems to make good sense if you have a healthy 401(k) balance, to put that money to use by paying off some of that balance. After all, there's no credit check and by borrowing against your account you're basically paying yourself back with interest.

While a 401(k) loan can have some benefits, there's a significant long-term cost because you're sidelining some of the retirement money that could be growing in your account.

A reader in New York is considering a 401(k) loan to pay off a credit card debt, be it Bank of America (BAC), JPMorgan Chase (JPM), Citibank (C), Wells Fargo (WFC) or another lender. It's an option, but one that requires serious thought.

Gabriel Cruz from New York writes:


I'm considering taking a loan from my retirement account to pay off credit cards. I owe $11,000 and I am still working, but I'm tired of paying the interest. I've heard this is a bad idea, but I'd like to know the details. I am also unclear about whether I would have to repay immediately if my job gets terminated and what the tax penalties might be.


Many 401(k) plans allow account holders to borrow money, but most financial advisers would say you should use this feature only as a last resort to pay off credit card debt.

Here's a look at common rules so that you can make the decision with your eyes wide open.

Rules for Borrowing

Most 401(k) plans allow borrowing, although they are not required to do so. You'll need to check your particular plan to see whether loans are permitted. If they are, make sure the plan doesn't restrict borrowing to a specific purpose. Some allow borrowing only for education, avoiding home eviction, buying your first home or paying medical expenses. (You can also find information on websites such as T. Rowe Price (TROW) and Charles Schwab (SCHW).)

Other features to check on:


*
How much can you borrow? Generally loans will be allowed for up to half of the account balance or $50,000, whichever is less. These are thresholds set by the IRS.

* Period of repayment. IRS rules require loans to be repaid in less than five years unless it's for a home loan and then it could be extended to 10 years or longer. The IRS requires the loan to be repaid in equal payments, at least quarterly, over the life of the loan. If the guidelines are not met, the loan may be considered an early distribution, taxed and assessed a 10 percent penalty.

* Payment schedule. Payments will be taken directly from your paycheck, so before you consider taking the loan, be sure it won't pinch your cash flow. If you're married, some plans may require your spouse to sign a consent form. It's not co-signing for the loan, but giving permission for the borrowing.

* Interest rate. Interest will be charged, but it's usually lower than commercial loans. Most plans use the prime rate plus 1 or 2 percent to set the rate. The prime rate is currently at 3.25 percent, meaning a 401(k) loan rate would be around 4 to 5 percent, depending on your plan. Bank loans average between 7 percent and 16 percent in New York, depending on the lender.