Can you borrow money from your 401(k) so you can use the funds to consolidate debt?
Yes, you can! But the real question is, will it be a wise financial move for you to do so? This money is for your future. Do you really want to compromise it just because you failed to control your credit use?
Apparently, a lot of people don’t mind using it. In 2019, a report from the Government Accountability Office was released revealing that $29.2 billion was withdrawn early by 401(k) participants. This was a report based on findings collected back in 2013 – 5 years after the Great Recession happened. According to this report, most of the withdrawals were done as hardship withdrawals and unpaid balances on a loan done earlier.
This report reveals that people do borrow money using their 401(k). Take note that early withdrawal is not the same as a loan. The former will not be returned. The latter has to be paid back.
You may think that this makes it even better! Getting a loan from your retirement fund would be like borrowing from yourself. You will pay it back anyway. If there is interest to be paid, it will be on you!
But is it really a good idea? With an uncertain future, should you really take the risk that can compromise your future?
Should you borrow money from your 401(k) for debt?
To determine if you should borrow money from your 401(k) to pay off debt, let us look at the advantages and disadvantages first.
One of the main advantages of getting a 401(k) loan is the fact that it has a lower interest rate compared to your credit cards. At least, if you are trying to consolidate credit card debts, this will help reduce how your debts accumulate significantly. And since this is a loan on your account, that interest will go to your fund anyway. Anything that you pay will make your fund grow further. Best of all, this transaction, although it is a loan, will not be recorded in your credit report. That means it will have no effect on your credit score.
When you have consolidated your loans, even if it is through your 401(k), you will immediately feel less stressed. The idea that you now owe money from your own account will make it less of an issue. And since it is consolidated, it will be easier to pay off. This will even make you focus on your retirement funds. The more aware you are of your 401(k), the more likely you will contribute to it. Just don’t let yourself feel too complacent about your debt situation. You still have to treat it as debt so you will be motivated to pay it off.
Now that we know the advantages, what about the disadvantages? There are also a couple of things that you need to consider.
A major disadvantage is it will derail your savings. The great thing about saving up for retirement early is the compound interest. The more money you have there, the more you will benefit through the interest rate. If you borrow money from your 401(k), you will reduce that amount and the growth possibilities through the compound interest.
You also have to face tax consequences and penalties when you get a loan – even if this is your money. You should also consider the qualities of credit card debt. Like the fact that it can be discharged through bankruptcy. If you consolidate your credit card debt and use your 401(k) to pay it off, you lose this ability.
Finally, borrowing money from your retirement fund will not address the underlying issue of why you were in debt in the first place. You need to identify the reason why it is hard for you to get out of debt that you had to rely on your retirement fund. Unless you deal with this, you will always be in danger of accumulating debt once more.
Rules when getting a 401(k) loan
It seems like the disadvantages outweigh the advantages of using your 401(k) to consolidate debt. But if you think about it, the disadvantages can be avoided. If your debt is causing you to feel stressed, then it is worth the risk. You just have to follow certain rules.
Start by knowing why you got into debt. You need to deal with that first. You cannot empty a bucket of water until you turn the faucet off. Is your debt caused by a medical condition that increased your expenses greatly? If that is the case, you might want to reconsider your debt solution. Keep your 401(k) untouched and just negotiate a better payment deal with your creditors. Consider other options first. If it is caused by overspending on your credit cards, keep your cards for now. Don’t use it until after your loan is paid off.
In case you have considered all the alternatives and you have calculated that the most practical solution is to borrow money from your 401(k), that is okay. But try to limit the amount that you will borrow. If possible, keep it within an amount that you know you can repay within 12 months. Be ready with a repayment plan. If you are not sure about your ability to pay it back, keep your hands off your retirement fund. If you default on your payments, it will be considered an early withdrawal and it will be hit with penalties and income taxes.
You should also continue to make contributions. If your employer is matching your contributions, you might want to make it as high as possible. This should be on top of the 401(k) loan payments.
Alternatives to deal with debt without borrowing your 401(k)
If you are still not sure if you really want to borrow money from your 401(k), that is okay. There are alternatives that you can consider.
- Negotiate with creditors. Start by communicating with your creditors and ask them to lower your interest rate. If you can manage it, have them lower your whole balance. Try to settle your debts. Offer a lump sum amount that you can immediately pay off. Whatever that amount cannot cover should be forgiven. They might relent if you negotiate properly. You’ll never know until you ask.
- Use balance transfer. There is also an option to get a new credit card account that offers a 0% introductory interest rate. If you can pay your balance in full before the 0% interest rate expires, you can enjoy huge savings on that debt.
These two options will work best if you have a good credit score. So if possible, work on improving your credit score. It will help you find the best terms to consolidate your multiple debts.
As you can see, you don’t have to limit yourself to your 401(k). You don’t have to borrow money from your retirement fund. Explore your other options before you make a decision. Look at your budget plan and your income. Analyze how much you can really afford to pay. It is already a good start that you are considering options to improve your monthly debt payments. It would be better if you chose the right debt solution to do it.