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Two years ago I took out a 401K loan to pay off my personal loan. Don’t gasp. Don’t shake your head. Don’t judge, or be judged, remember? Most financial bloggers recommend to never borrow from your 401K. They are right: the risks of taking out a 401K loan outweigh the benefits by far.
However, I believe that there is no general formula that works the same for everyone.
Every person’s circumstances are unique. Many factors should be taken into account when considering a 401K loan. In my situation, taking out a 401K loan was the best move that I have ever made in paying off my debt.
A few years ago I had a personal loan. The interest rate was about 16%. Trying to reduce my payments, I re-financed it for another five years at a lower rate of 11%. Paying off this personal loan felt like a never ending roller coaster ride. I hate roller coasters, so I decided to look at other options, i.e. a 401K loan.
The interest rate on my 401K loan was 4.5%, and I was paying this interest to myself and not to the bank.
Automatic Payroll Deduction
You are probably ready to throw at me that argument about making more than a minimum payment on my loan, trying to pay it off faster. This strategy never worked for me. If you’ve been reading this blog for sometime now, you know why – I am a spender, not a disciplined saver.
You also can argue that I could set up automatic payments for my personal loan. Please, don’t be naive and think that I have not tried that. Sometimes extra money miraculously converts into an extra pair of shoes. Or a new handbag. Or a new coat.
I needed money to go directly into the account where I had no say, and those automatic payroll deductions served this purpose well.
Borrowing from Myself
The money I borrowed from my 401K was money that belonged to … me. I literally borrowed from myself. I especially loved the fact that this loan was not reflected on my credit report. In fact, my credit score went up about ten points as soon as my personal loan got paid off. 401K loans are not reported on credit reports.
Please note, however, that even though I took out a 401K loan, I never stopped contributing to my 401K account.
Would I take out a 401K loan again? To be honest with you, I have to say that I would not do it again, unless I would be facing an outrageous financial disaster that my emergency fund would not be able to cover.
Loss of Employment
My biggest fear was that I was going to lose my job. I wanted to pay off my 401K loan in the shortest time that I could afford. That time appeared to be two years. We all know that a lot can happen in two years.
If I’d had lost my job within these two years, the balance on my loan would become due within 60 days according to my loan agreement. There was no way I would be able to come up with all that cash that I took out from my 401K plan and put it back in.
I decided that if it did come to this and I lost my job, I would treat this loan as a withdrawal and somehow pay taxes and a 10% penalty. Somehow this meant that I would have to take out a personal loan (again!) to pay taxes on that 401K distribution. However, it was a risk I was willing to take.
Loss of Return
I decided to forgo any return I could have potentially earned on the amount that I borrowed within those two years. Markets were not doing that great anyway, so I figured that paying myself 4.5% in interest and still making regular contributions to my 401K plan, was well worth it.
I chose to take certain risks and forgo certain benefits for one reason only. I wanted to pay off a huge amount of debt in two years. As I said before, everyone’s situation is different. The benefits of doing it, in my case, outweighed the risks.
This article was featured in the following carnivals:
Festival of Frugality at The Frugal Toad
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Carnival of Retirement at Finance Product Reviews
Carnival of MoneyPros at Financial Conflict Coach
Canadian PF Happy Hour at Canadian Personal Finance
Yakezie Carnival at 20s Finances
Financial Carnival for Young Adults at Young Family Finance