How to Borrow from Your 401(k) to Pay Off Your Debt

I’ve read the snowball vs. avalanche method of paying off debt, and I figured I’d tell you about my own personal method—or at least, the one that I’ve used a couple of times over the last few years that has helped me tons. This method requires that you’ve been saving for retirement via a 401(k).
My stats: I’m 28, working full-time with a good company, and graduated with about $22,000 in student debt. I’m not rolling in the cash (I earn about $44,000 before taxes), and I don’t have outside help, and never have. The ‘rents cut me off at 18. It was an “I did it, so you can do it” sort of scenario.
I managed to avoid all the economic downturn problems by keeping the full-time job I had during school after I graduated, which meant that I started my 401(k) fairly early for someone in our age group. Interestingly, that college job was as a 401(k) customer service rep, so I knew early on the importance of starting a retirement savings plan as early as possible. I knew that over time, the savings would pay huge dividends (pun intended). In my training for said job, we were taught that taking money out of a 401(k) early (pre-retirement age), for almost any reason, is “bad.” And in a lot of ways, I agree with this view, but having a 401(k) nest egg at an early age, while still supporting some debt, has provided me with an interesting alternative to the snow/avalanche equations.

Recently, I paid off my largest school loan ($16,000) with a 401(k) loan. I don’t know if most people are familiar with the option, but a 401(k) loan allows someone to borrow money out of a 401(k) (as opposed to against it), which means that there is no credit check or anything credit-related going on. Further, while there is interest that must be paid on a 401(k) loan, it is paid back to the borrowers own account.

In explaining this to customers, at this point people usually ask “Why should I pay interest on money I’m borrowing from myself?” Quite simply, because the IRS says so. They require that there be an interest component in a 401(k) loan simply so that you’re not utterly crippling whatever retirement savings that you’ve managed to scrape together. In reality, that interest rate is going to be much lower than what a well diversified portfolio is going to earn on the market, but it’s a) better than nothing, and b) better than paying a bank what is probably a much higher rate. The student loan I just killed off had an interest rate of 7.5%, and my 401(k) loan is only 3.75%. Sweet!
Further, the loan payments from a 401(k) loan comes directly out of the paycheck, as opposed to from a checking account, so by the time I get my paycheck, I don’t have to think about the payment being on time or late or anything. No late payments, ever.
I have used this method a couple of times. This most recent loan was definitely the largest so far, but previously, I have taken smaller, shorter term loans to pay off high interest credit cards, and to pay off my car. I’m talking $1,500 over 12 months, or $1,200 over 9 month, that sort of thing. Each company has its own rules about how much can be borrowed and how you can structure the terms of the loan, but in my experience (and I’ve seen a lot of plans) most plans are pretty flexible. Sometimes there is a fee for taking a loan out (smaller the company, generally the higher the fee) usually around $35 to $50, and it’s usually taken out of the 401(k) account directly, so it’s not hitting your paycheck.
The biggest thing to watch out for, by far, is if you leave employment while you have a loan outstanding. It doesn’t matter how you’ve left your now former employer, whether voluntary or not, but when you do, you will have to either pay back that loan in full (most companies’ plans give you a 90 day window), or you have to pay taxes on that outstanding balance. Taxes means you will owe the IRS whatever your normal income tax is, based on your tax bracket (and remember, that loan balance will count as income in that tax year, so depending on your income and how big the loan is, getting bumped up into a new, higher tax bracket is very possible) plus a 10 percent early withdrawal penalty on that outstanding balance.
So the 401(k) loan is not for everyone. Ideally you’d be somewhat younger, and working a stable job where you’ve started your 401(k). Me, I’ve only ever contributed the minimum amount to get my full employer match, so it has just sort of worked out for me—the rest of my paycheck has been mostly going to rent, beer, and traveling. I’m bad at diligently paying down debt.

I would definitely NOT recommend using these for anything frivolous or unnecessary. I’ve seen lot’s of people use them to buy a nicer car, when they already drive a perfectly good beater, just because they did a quarterly check up on the 401(k), saw the bigger than expected number and thought “I’m rich!” No, you’re not. But if you leave it alone, then when you turn 59 1/2, you will be. So be disciplined! Don’t buy things that you would otherwise not be able to afford! This can be an interesting way to get rid of some nasty bills. If you’re killing debt, I think that’s a pretty solid use.
Cheers and happy savings!


19 Comments / Post A Comment

SterlingCooper05 (#2,529)

Using a 401k loan to pay off other debt is definitely a bad idea, unless you’re facing the worst case scenario of bankruptcy. Most people WILL leave their current job in the future and a 401k loan is just another thing to worry about at an already stressful time. Also, it effectively is a refinance not a PAYOFF. Big difference, especially when the loan comes due upon termination. It reminds me of the people that used their home equity to pay for college, cars, etc. We all know how well that turned out.

awk (#840)

@SterlingCooper05 Agreed. Some of the worst advice I’ve seen on the Billfold ever. It makes sense in some cases, but those cases are rare. As long as your debt interest rate is lower than the ROI in your plan, it’s not worth the risk. What if you get laid off tomorrow? It’s unnecessary risk for a negligible return.

@SterlingCooper05 You guys realize it’s not a real loan in that you’re not actually indebted to anyone except yourself?

So “due upon termination” really means if you don’t re-fund your account before a grace period (I think 30 days?), the remaining amount is treated as an early withdrawal and will need to pay the taxes and penalties to the IRS.

The actual cost is the opportunity cost by not having that money growing tax free.

awk (#840)

@forget it i quit Yes, I think we both realize that. And I’m saying that the opportunity cost is greater than the value of paying off low interest loans. Now, if the person has CC debt with an interest rate of 19 percent and a 401k earning 6 percent interest, sure, it makes sense. But this author is telling us he pulled out $16k to pay off a loan with 7 percent interest! That $16k should have just stayed in there as long as it was earning more than 7 percent, that is.

Quufer (#2,754)

I’ve actually done this twice, and am about to do it again. First time was to pay for my wedding, since my wife and I were responsible for 100% of the costs (guest count was under 50, so it’s not as if we were splurging). Second time was last year when I was going to be working abroad for my company for 90 days, but reimbursed for travel and other expenses only after the trip was complete. These are both now paid off. I actually changed jobs a few years back, with loan #1 still outstanding, and didn’t have to pay it back any sooner than I would have otherwise, though I also couldn’t rollover my 401k until it was paid off.

Now, my wife and I are buying a house, and we’re using a 401k loan for the bulk of our down payment. We have the income to support paying off both the mortgage and the 401k loan at once, and it allows us to buy a house now, when the market is down and interest rates are almost nothing.

So I actually agree with the OP that 401k loans, when used judiciously and for a major, actual need, are a really useful tool. Like any financial tool, of course, they can be abused, and my situation (only 3 jobs in 11 years of working, expectation of continued employment for the forseeable future) may be especially conducive to their use. But it’s not something that should be dismissed out of hand.

3jane (#645)

I’ve always worked in the non-profit industry, so I honestly don’t understand the differences (if there are any) between 401ks and 403bs, which is what I’ve always had. So, assuming it is even possible to get this kind of loan out of a 403b, is this a less-terrible idea if your 403b is fully vested (meaning you take it with you when you leave your job)?

SterlingCooper05 (#2,529)

@3jane 403b’s are basically 401k’s for people working in tax exempt organizations. I have a 401k and my wife has a 403b, but were both invested in the same funds.

Also, you can only borrow from your vested balance.

ThatJenn (#916)

@SterlingCooper05 Thank you! I never really got the difference. I have the option of a 403b since I work at a university, but I have been totally confused by everyone saying I should look to see if my employer offers a 401k – I mean, I obviously wasn’t invested enough to look it up since I already contribute a bunch to my Roth IRA and my required retirement plan, but it’s still good to know for when I do have a little more cushion and am ready to start contributing more than what I do, which will require a new account.

@ThatJenn You should check if your 403b has any matching contributions, that’s basically free money if you plan on staying long enough for it to vest.

ThatJenn (#916)

@forget it i quit Sadly, no, which is why I haven’t bothered to open one yet (and won’t ’til my emergency savings are where I want them). Though I do have a separate state retirement plan through the state without a number/letter code (hi I know I sound financially illiterate – but basically it’s the state-administered plan that’s the alternative to their pension plan, which I didn’t pick because I really don’t trust my state to be solvent by the time I retire) that gives me a really sweet match. It actually used to be JUST free money with no employee contribution, but the state realized it was going broke and mandated a 3% contribution from employees as of last year. People complain about that, but I don’t mind – the only thing that’s mildly inconvenient is that exactly 3% from me and 6% from my employer gets put in and I can’t put in any extra, so between that and maxing out my Roth IRA every year, I would need to look around for another option if I wanted to save any more.

The best part about this comment is that I misspelled “illiterate” on my first try.

Derbel McDillet (#1,241)

@ThatJenn I worked for a company for a little over three years that had a 10% contribution with no match required! It was amazing! The only catch was, it took three years to be fully vested. They finally changed it to a more typical 5% contribution/5% match right before I left (fully vested, whoohoo!).

ThatJenn (#916)

@AconyBelle Sweet!!! Waiting to get vested is the key. I could get vested in this program in one year, OR I could go with the quickly-faltering pension plan that took EIGHT YEARS to get vested. Seriously, what percentage of people currently in their 20s will be at the same job eight years from now?! Three years also would have made me sad, but it’s a little more livable. My partner gets vested in his company in stages over five years and is finding himself sort of miserably hanging on to a job he doesn’t really want while in school part-time (when he could technically afford to quit and go to school full time instead) just to get to that five year mark. Blech. (I mean, I do get why those rules exist, they just seem sort of painful in this particular era when careers nearly always happen in multiple places.)

ImASadGiraffe (#982)

I’m about to pay back the balance of a 401k loan (actually TSP since I’m a government employee). It was pretty painless, and I’m paying it off way early because I can and there’s no prepayment penalty. I had a vet emergency with my dog and this was the cheapest option, credit card would have been way more expensive.

Jeni Vidi Vici (#1,121)

I just took a look at my own account (TIAA/CREF) and found that in my case, if I take out a 403b loan and then lose my job, it isn’t immediately callable. I can just continue making the planned loan payments. Not sure how common that is, but it makes the idea a lot less scary.

sony_b (#225)

I’ve done this twice, once to consolidate a bunch of credit card debt with ridiculous rates that I had racked up in grad school (no regrets there, I saved a ton of money on interest), and again this year to do basically the same thing when we put too much on plastic while buying our house and moving into it. No regrets there either. The second time around the cash savings was negligible, but the psychological win of getting all the plastic back to zero (and not letting it rise again) is worth it.

Derbel McDillet (#1,241)

My husband did this when we bought our property and needed to install a septic system (hello, rural living!). It’s been totally painless and will be paid back in full this year.

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