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.
Interest Rate
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.
Conclusion
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.
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I don’t have a 401K but if I did I would strongly consider doing the same thing you did. It must have felt nice to get the personal record off your balance sheet
Huge, huge relief! I loved watching the balance to go lower and lower. And it moved fast. 🙂
Very pleased it worked out for you, and I think you’re right about tailoring decisions to each individual’s unique circumstances. I’m less sure though that a happy conclusion validates the decision? How might your retrospective conclusions about your choice change if you’d been laid off while a substantial portion of the 401k were still outstanding?
I don’t have any regrets. I took certain risks. I knew what I was doing and what possibly could happen. I am lucky that it all paid off in the end.
I’m glad it worked out for you! The 16% return you got by paying off that loan is probably higher than what you would have gotten in the market anyway.
Hopefully you’ll avoid more debt in the future. 🙂
Actually, I think borrowing from the 401k to invest in 401k (with matching) is a good idea. With company matching, you gain 100% right away and you are paying yourself the interest.
Joe, I am sooo trying not to get into debt anymore. Not worth it!
It doesn’t matter what other people say. The smartest plan of action in the world won’t matter if you can’t follow through on that plan. Doing what works for you is always the best path.
I’m glad it worked out for you. The big negative is paying it back if you are no longer employed, but you took that into consideration so good for you. Everyone has to do what works for them. I think so many PF people say don’t do it because most people don’t have the resolve to pay it back.
Honestly, I am not sure I had a resolve to pay it back in case I’d lost my job. I took a lot of risk. But it paid off.
I’ve never done the math, but according to Suze Orman, 401(k) loans force you to pay income taxes twice. You repay them with after tax dollars and then you pay taxes again when you withdraw the money. Although I think people should do what’s best for them, in general, 401(k) loans are a bad idea. The biggest risk is you’ll lose your job and have to repay the money within 60 days. If you can’t, taxes and penalties follow. Now, instead of owing yourself, you owe the IRS. Not an attractive trade.
That is correct. I chose a double taxation. For me, it was worth it. 401K loan carries a lot of risks. But there are some benefits to it as well.
Thanks for sharing your story. You’re right – it all depends on personal circumstances, right? Sandra told her own tale of borrowing from her 401k on our blog: http://blog.creditkarma.com/loans/the-pros-and-cons-of-borrowing-from-your-401k/
I would never judge anyone for this. First of all, Jeff did this several years ago…and then actually switched jobs! :/ It was pretty detrimental to the loan, but switching jobs was the right thing to do at that time for him. Thanks for sharing your story and for keeping it real, Aloysa!
Switching a job is tough as it is, but with 401K loan balance in tow, it is even worse. Did you pay off your loan or did it choose to get taxed?
The whole double taxation thing is a bit of a misnomer. Sure, the repayment dollars going back in are post-tax, and those dollars will be taxed again when you retire, but the dollars that you are loaning yourself have never been taxed and the interest those dollars would have gained in your 401k would also be tax free.
Then there’s your loan account. The dollars you would normally use to pay it off would be post-tax, but here you are wiping it off the books from an entirely tax-free source… and then converting a huge interest payment to a much smaller one and redirecting it to yourself.
In the battle of which toilet is smallest, I’m pretty sure you’ll find a whole lot less will get flushed down the 401k John, AND it’s autoflush. You just have to be sure it doesn’t explode on you.
But finally, I think one of the worst side effects of the recession has been our collective withdrawal to our shells. We’ve stopped taking chances. We’ve lost faith in ourselves. Taking excessive risk is one thing, but not taking enough can be just as bad. God forbid we invest in ourselves.
I agree about taking chances. As long as we think and analyze all pros and cons, and as long as we are honest with ourselves about how much risk we can tolerate, we should take chances. People are too careful to the point living by the book. Write your own book, right? 🙂
I think it depends on each person’s individual situation. If you have a job that you do not plan on leaving the company before you pay the loan off and even in this uncertain economy have a small chance of being downsided or losing it, it is a much better alternative than conventional financing.
However, it can be financially devastating if you do change or lose your job with a large outstanding 401K loan that you cannot get financing for.
I didn’t think I would ever leave the company I was with. but out of the blue, I got a much better job offer at another company and didn’t even think about the 401K loan before making that decision and ending up having to put nearly $2,000 on my high-interest credit cards to pay the taxes and penalties.
OK, not judging, not judging… I definitely don’t live in a glass house.
So, I think you lucked out that the markets didn’t do all that great when you took out the loan; otherwise, it really could have backfired on you. And you make good arguments with regard to repaying yourself interest instead of the bank.
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that was smart. why pay other people interest if you can pay yourself. the 4.5 you are paying yourself should be compared to the opportunity cost of what it could otherwise be earning. almost anyone would save the 16% on your original loan. kudos. smart moves are how you get to the 1% club
Exactly! I don’t view 4.5% as something negative. Quite the opposite. 🙂
All spending, all investing, all borrowing has risks. You seem to have weighed your options and it worked out well for you.
However, this is one area where a Roth IRA is beneficial. If you need to borrow against your retirement savings, you can withdraw some of your Roth without penalty, interest or fear of losing your job, but it has the same loss of return.
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Sometimes you have to do, what you have to do. Only time i judge is when people use it as a personal savings accounts, instead of working towards building an emergency savings for unexpected events.
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Although late to comment, I wanted to ask those that come across this post to consider an option where you want flexibility in your liquidity options. In other words, if you lost your job you have two choices – take the entire amount of your 401k or none. At least this way you decide which portion of your 401k to take and pay taxes.
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