Given plunging stock prices, declining home values and the rise in unemployment, it's no surprise that many Americans are looking for ways to get their finances in shape. For example, recently I got a question from a reader asking if it was a good idea to borrow money from her 401(k) plan to pay off high-interest credit card debt.
While my initial gut reaction was a resounding "no, don't you dare," I reconsidered. Without doubt, your retirement account is a crucial component of your long-term financial plan; for many people, it is the crucial component. However, if you understand and follow the stringent rules for 401(k) borrowing, and if you are extremely confident you can pay the money back in a timely fashion, this can be a smart move. But caution lights abound; think carefully before you leap.
Understand the Terms
Start by making sure you fully understand the terms at which you're borrowing. Typically, you can borrow up to 50 percent of your vested balance up to a $50,000 maximum (but note that some plans have different rules). Your rate will be quite low, perhaps 5 percent, and you'll most likely have to pay the money back within five years (note that if you're borrowing to buy a home, you have longer to repay the loan -- but that's a different story). Of course, you'll be paying the interest to yourself, perhaps through an automatic payroll deduction.
Understand the Risks
Now if you've got credit card debt at, say, 15 percent or even higher, then paying it off at 5 percent (back to yourself) can seem pretty attractive. And it is, both in a financial sense (lower total interest costs) and a psychological one (having no credit card debt can be a very good feeling). But there some significant caveats:
-- Your monthly payment could actually be higher. Credit card balances can be repaid in such small increments you can take years or decades to repay them. Your 401(k) loan will likely have to be repaid within five years. If you have a lot of debt, you may not see that much monthly relief, despite the lower interest rates.
-- When you repay the loan, you're using after-tax dollars, thereby forfeiting the tax advantage of a 401(k) plan. Since you'll also have to pay tax when you eventually withdraw the money, you're in effect making yourself subject to double taxation.
-- You miss out on the investment potential of the money you borrow. That might not seem too dire in today's environment, but if the markets start growing while you're paying the money back, you might miss some real opportunities for growth.
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