How to pay off debt with a 401(k) loan: Very carefully

By Jeanne Lee/NerdWallet

Most people consolidate debt with a personal loan or a balance-transfer credit card. Others tap the equity in their homes. These options all come with risk.

By comparison, taking a 401(k) loan might look benign -- but it could be the riskiest choice of all.

Most 401(k) plans allow users to borrow against their retirement savings. "About 1 in 5 of our plan participants do have a loan outstanding," said Meghan Murphy, a spokesperson for Fidelity Investments.

Interest rates on 401(k) loans are low -- typically one percentage point above the prime rate -- and interest payments go back into your account. But if you lose your job, you face accelerated repayment or taxes and penalties.

Ten percent of 401(k) borrowers default, according to the National Bureau of Economic Research. Of those who leave their jobs with a loan outstanding, 86% default.

Even a fully repaid loan dents your retirement plans. The money you borrow won't earn investment gains outside of your 401(k), and once repaid, it still can't make up for lost time.

For these reasons, financial experts typically caution against 401(k) loans except as a last resort.

Under what extreme circumstances might a 401(k) loan be acceptable?

Financial planner Sterling Neblett of Centurion Wealth Management in McLean, Virginia, works with one couple who were once swimming in debt. He suggested they go ahead with the loan -- and it proved to be the right option.

The Washington, D.C.- area couple had racked up more than $70,000 in credit card debt. Payoff seemed impossible. With rates around 20 percent, interest consumed huge chunks of their payments.

"They were terrified that they would never get out from underneath this massive high-interest-rate debt," he said.

Their debt piled up while they lived on a single salary after relocating to the high-cost area. Kids' expenses, moving costs and more went on their credit cards. Then the wife started a new job, bringing their combined income to about $200,000 per year and motivating them to tackle debt, Neblett said.

He and the couple decided a 401(k) loan was the best way to pay off their credit card debt. 

Here's what Neblett considered: 

The interest saved by consolidating debt. The couple could pay 4 percent on the 401(k) loan or 20 percent on their credit cards -- so taking the loan saved them nearly $25,000. The interest they did pay, about $5,250, was reinvested into the 401(k).

"We don't do 401(k) loans often," Neblett said, "but with that couple it would have taken them probably double or triple the amount of time to pay off their debt with the 20 percent interest." 

The retirement hit. Someone taking a $50,000 five-year loan -- the maximum allowed by law -- at 4 percent interest would have a 401(k) balance $4,957 lower by the end of the repayment period, according to Vanguard's retirement plan loan calculator, assuming the money would have earned 7 percent returns if left invested in the account. At that rate, after 20 years, that gap would grow to $20,024.

To make up that lost ground, Neblett advises borrowers to continue making scheduled contributions to their 401(k) as they repay a loan, if possible. The next best thing is to contribute at least enough to nab any employer match. 

The risk and cost of default. To the IRS, a default on a 401(k) loan is a taxable distribution, and those younger than 59½ incur a 10 percent early withdrawal penalty. Had the couple working with Neblett failed to pay, the IRS bill would have been $17,500: $12,500 in income tax (assuming 25 percent bracket) and a 10 percent penalty of $5,000.

Neblett considered the couple's high income and thought the relatively small risk was acceptable in exchange for eliminating the toxic debt. 

A disciplined repayment plan. 401(k) loan payments are fixed and typically deducted automatically from a borrower's paychecks, making them easier to manage than credit card payments. "Out of sight, out of mind," Neblett said.

He advised the clients to use auto-deductions and personalized a budget to keep them on track with payments toward their loan and remaining $20,000 in credit card debt.

He says the couple was highly motivated, which was equally key to a successful outcome. They stuck with their plan, and -- after receiving a salary increase -- managed to pay off the 401(k) loan early.

"I'll never forget her tears of joy when four years later -- not five -- we had a credit card cutting 'party' to celebrate them paying off all their debt apart from their mortgage," he said. 

Other options for consolidating debt include balance transfer cards and personal loans, which don't require any collateral. Approval and interest rates for these types of loans are based on credit and income.

Balance transfer cards offer promotional rates of 0 percent for a limited time, usually no more than 21 months. But they require a high credit score, some carry transfer fees up to 5 percent, and $15,000 is typically the largest amount you can transfer.

Personal loans typically have lower interest rates than credit cards. The best rates go to those with strong credit. Those with bad credit might need a co-signer to qualify.

Anyone considering debt consolidation should first: 

Do a reality check. Does your unsecured debt -- credit cards, medical bills, personal loans -- total more than 50 percent of your income? You might need to seek debt relief through credit counseling or bankruptcy.

Halt new debt. Go three to six months without using your credit cards. Once you've reset your spending habits, you can consider a debt consolidation plan.

Make a budget. Like the couple with whom Neblett worked, you need a plan that supports repayment within five years. A fresh start won't work if you spend beyond your means. 

This article originally appeared on NerdWallet.