You’ve found yourself in the situation where you have enough in your retirement account to pay off your credit card balance. If that retirement account happens to be a 401(k), you may have the option to take a loan against the balance, instead of making a withdrawal.
With a withdrawal, you’re going to owe taxes, plus a penalty, depending on the situation. And with an IRA, you don’t have any other options; but, if your employer allows, you can take a loan from your 401(k). And with a loan, you might pay a small fee (mine is $75) for them to issue the loan, but any interest you pay goes back into your own account. So, you’re paying yourself the interest, instead of the credit card company.
But does it make sense to take a loan in order to pay off your credit card? Well, that depends – on a number of factors, including the interest rate on your card.
In order to figure out whether it’s financially wise, we need to look at the potential savings as well as the opportunity cost of taking that loan.
So, let’s walk through a simple way to estimate the financial impact (and then we’ll look at other impacts taking out a loan might have):
Your credit card interest rate is 19.5%. You earn an average of 12% on your investments. Your 401(k) loan’s interest rate is 5%.
So how much will you save by taking out the loan? 19.5% (credit card rate) minus 12% (average investment rate) = 7.5%. But what about the interest rate you’re paying on the loan itself? Well…you’re paying that interest rate to yourself, so it really doesn’t “count.” It’s a wash – you’re paying more, but it’s going back into your account. So, for simplicity, we’re going to ignore that piece of the puzzle.
You’re going to save 7.5% each year overall, less the $75 loan fee. This is an oversimplification, of course; but it’s a great way to estimate your savings.
Then, you have to figure out whether that level of savings is worth pulling the money from your 401(k). There are other considerations which are explored a bit more here and here, such as the need to repay the loan if you leave your job. Or maybe the security of having that money in the bank is more valuable to you than having the credit card paid off. Those are personal decisions, and no one can help you make them.
Personally, we want to maintain the greatest possible level of flexibility while minimizing our monthly expenses. Right now, we’re focusing on paying off debts and getting rid of stuff, so taking out a 401(k) loan is something we’re considering to knock out a high-interest debt. At some point, though, we’d also have to consider whether just pushing harder to pay it off was a better choice than touching our retirement nest-egg.
What other considerations have you taken into account? What did you ultimately decide was best for you and your finances?