It’s not a good idea to use 401k loans to pay off credit cards. It might be acceptable as a last resort in some cases, but it’s definitely not the best way to deal with the problem. Taking money out of your 401k endangers your retirement, makes you miss out on investment returns, and could result in expensive penalties.
When you get a loan from a 401k, you’re removing money from your retirement savings. The idea is that you’ll pay it back and still have that money for retirement. But if something happens and you’re unable to repay the loan, you’ll be set back and could potentially have to retire later.
Another dangerous aspect of a 401k loan is the risk of penalties. You usually have 5 years to pay off a 401k loan. But if you lose your job, you need to repay the loan or roll over the outstanding balance into a new retirement account within a certain time period. The deadline is the date when your tax return is due for the year the loan distribution occurred. If you don’t meet whichever of those two deadlines applies to you (5 years or when your tax return is due), you’ll owe a 10% early withdrawal penalty and have to pay income tax on the loan amount. If you pay the loan back by the deadline, you won’t owe the income tax until after you retire.
Taking money out of your retirement account also means that it’s not currently invested. So if the market improves, you’ll miss out on getting that extra value. But you will pay interest on the 401k loan, usually the prime rate + 1%, and that interest goes into the retirement account itself (since you’re borrowing from your own savings). So the interest can help make up for some of the gains you may lose.
Why you shouldn’t use 401k loans to pay off credit cards:
- You owe a 10% early withdrawal penalty and income tax if you don’t repay the loan on time.
- Your retirement could be in jeopardy if you can’t pay the money back.
- You miss out on investment returns for the money you take out.
There are plenty of better alternatives to getting a 401k loan to pay off credit cards. For instance, consider moving your current credit card balance to a 0% balance transfer credit card or getting a personal loan for credit card consolidation.
A balance transfer credit card can give you anywhere from 6 to 21 months to pay off your balance interest-free, after which point any remaining balance accrues interest at the card’s high regular APR. If you have the good or excellent credit usually necessary to get such a card and think you can pay off the entire balance during the 0% period, that could be the best option for you.
A personal loan is a better option if you won’t be able to pay off your credit cards quickly. If you have excellent credit, you could potentially get APRs as low as 4% to 6%, which is extremely cheap compared to even the best credit card APRs. If you have good credit, you might not be able to get the absolute lowest rates, but you should still get a fairly cheap APR considering most personal loans have credit score requirements 40+ points below the start of the good credit range.
If all else fails and you do take out a 401k loan as a last resort, commit to paying it back as quickly as possible. Even if your retirement seems far away, most of us need all the time we can get to build our money so that we’re well taken care of.
WalletHub Answers is a free service that helps consumers access financial information. Information on WalletHub Answers is provided “as is” and should not be considered financial, legal or investment advice. WalletHub is not a financial advisor, law firm, “lawyer referral service,” or a substitute for a financial advisor, attorney, or law firm. You may want to hire a professional before making any decision. WalletHub does not endorse any particular contributors and cannot guarantee the quality or reliability of any information posted. The helpfulness of a financial advisor's answer is not indicative of future advisor performance.