401(k) loans aren't the answer

Written by
Peter Dunn

This weekend in my Indy Star column I answered a very common question. And while it's a common question, it's one with very serious implications.

I’m dealing with some pesky credit-card debt, and I’ve been racking my brain to come-up with the easiest solution. I’ve decided that a 401(k) loan makes the most sense. Please tell me I’m right.

— Ken

You should have read this question and started immediately shaking your head, and screaming NOOO! There are two specific reasons taking out a 401(k) loan to pay off debt is always a bad idea. The first is because the easiest solution is rarely the best one. And secondly, a 401(k) loan sounds like a sweet deal, but really it isn't.

"Credit-card debt is a manifestation of your past. When you rectify your past (debt) with your future (401(k)), magic isn’t the result. Two wrongs don’t make a right. It’s actually two bad decisions stacked on top of each other. If you took a $10,000 loan on January 1, 2013 to pay off your credit-card debt, then you would have shielded $10,000 from a 30 percent growth year (the S&P 500 return). Sure, you paid yourself some paltry amount of interest, but you missed out on a 30 percent return."(courtesy of the Indy Star)

I want you to really understand this first concept, paying off debt the easy way will not solve the problem. Okay, it does solve the problem of having debt today, but I would not be even a little bit surprised if in one year or two years you are right back in the same debt situation. Why? Because you did not break the habit of accumulating debt. Paying off debt with a lump sum from an inheritance, a 401(k) loan, or by liquidating assets doesn't take the same discipline you would learn if you paid off debt the slow and steady route. By cutting expenses and focusing on one debt at a time you feel the lesson deep in your bones. Debt is bad and you never want to be in this spot again.

And then there's the reality of a 401(k) loan...

"Most 401(k) loans must be paid back in less than five years. The interest rate is relatively low, and the participant does end up paying the interest to himself. But the “paying yourself” interest argument is the equivalent of driving 90 miles to get cheap gas.You should also know that if you leave your current job, your 401(k) loan will become payable immediately. This means that if you can’t pay, you will owe taxes, because your loan will be classified as a non-qualified withdrawal. And don’t forget the 10 percent penalty you will owe if you are younger than 59 ½." (courtesy of the Indy Star)

Sorry Ken, taking out a 401(k) may solve your immediate problem, but it's guaranteed to create many more problems in the future. Make a plan, set a goal, and work hard to pay off your debt. It will suck, but you will gain a healthy view of debt and maintain your current retirement plan projections.

Step up your financial wellness game.

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