Should you borrow to repay a 401(k) loan?
Posted
Jul 31 2009, 08:33 AM
by
Karen Datko
Rating:
This post comes from partner blog The Dough Roller.
One of the features of many 401(k) retirement plans is that you can borrow money from your own account. While 401(k) plans are not required to permit plan participants to take out loans, many plans do.
Much has been written about the pros and cons of 401(k) loans. One of the potential drawbacks comes into play if you leave your job (voluntarily or otherwise) while you still have an outstanding loan from your 401(k) plan.
When this happens, you generally have two options: Pay back the loan in full within 60 days, or don't. If you follow the second option, the IRS will treat the loan as an early withdrawal from your 401(k) plan and, with some exceptions, smack you with a 10% penalty of the outstanding loan amount AND require you to pay taxes on the distribution.
Thus, you could easily end up paying 30% or 40% of the outstanding loan amount in penalties and taxes. It goes without saying that failing to pay back the loan can be a costly decision.
A problem that often arises, however, is that folks want to pay back the 401(k) loan, but can't afford to do so. Particularly in difficult economic times, many people are let go and lack the available funds to repay the loan. And that raises an important question: Should you borrow to repay a 401(k) loan?
The short answer, in my opinion, is absolutely yes. And to my surprise, it's also Dave Ramsey's advice, and we all know how much he preaches against nonmortgage debt. Between the taxes and penalties you'll owe if you don't repay the 401(k) loan, the cost will almost always be greater than a short-term loan at reasonable rates to repay the 401(k) loan. In addition, by not repaying the 401(k) loan, you forever remove that money from your retirement investments, thus losing the tax-deferred return on your 401(k) investments forever.
But the question still remains, where should you look to borrow money to repay a 401(k) loan? Here are a few alternatives:
- Home equity line of credit. Perhaps the first option would be to tap a home equity line of credit. Equity lines generally come with reasonable interest rates and are easy to access.
- 0% balance-transfer cards. Another potential option is to take advantage of one or more 0% balance-transfer offers. Before going this route, however, make sure you can pay off a 401(k) loan with the balance-transfer card. Also keep in mind that the introductory rate periods are now generally just six months. After that, the interest rates adjust to whatever regular APR applies to the card.
- LendingClub. LendingClub offers unsecured loans up to $25,000. Depending on your credit history, credit score, and other factors, you can obtain a loan at a reasonable interest rate. All loans must be repaid over three years, although you can choose to pay off the loan sooner.
- Unsecured line of credit. You can obtain unsecured lines of credit from most banks and credit unions. Interest rates will vary significantly based on your credit history. I have an unsecured line at Citibank that I rarely use, but it does come in handy for short-term loan needs.
What's your take? Should you borrow to repay a 401(k) loan if you don't have the funds available to repay the debt?
Related reading at The Dough Roller:
OptionsHouse review
The college student's guide to credit cards
Balance-transfer smackdown
