on January 5, 2012

One of the major pitfalls to acting on financial advice given to a general audience is that the advice iswell, general. A perfect example revolves around using a 401k to pay off debt. If a consumer was to read several personal finance books and blogs, they would easily come to the conclusion that you should never use a 401k to pay off credit cards. I disagree with that conclusion and say that sometimes, using retirement funds to get out of debt can make very good sense .

Now do I think many of the personal finance bloggers and authors are wrong?  No, I agree that in general there are more reasons to not use retirement funds to pay off debts than there are to use them.  Never the less, consumers should be aware that there are instances where borrowing from a 401k to pay credit cards can make great sense and if they feel they are in a situation that might call for that, they should seek specific advice for their unique circumstances.

Should I borrow from 401K to Pay Credit Cards?

This is one of the most common questions among my clients who have money in a 401k. As you can imagine, my answer to that question is, it depends. To help determine whether or not a consumer should be using a 401k to pay off debt. I like to break it down into 2 factors.

1. Financial habits and attitude.

We first have to analyze the overall financial situation and determine what caused the consumer to get into debt in the first place. If we do not first identify and correct the habits and circumstances that created this situation, than borrowing from your 401K to pay off your debt would be akin to bailing out a sinking boat without first plugging the leak. No matter how much or how fast you bail, you will eventually sink.

Perhaps the consumer needs to take a hard look at their life style and how they have been spending their income. Many consumers have never put together a spending plan and really have no idea where all of their money goes each month. If this lack of financial awareness is not corrected, then the chances are very high that the consumer will simply be back in debt within a few years, but this time, with a much smaller 401k.

2. Financial circumstances and options.

Figuring out factor number 2 is actually much easier than factor number 1. It is a breeze to punch numbers, look at interest rates, and lay out all of the options that are financially feasible for a consumer to reach a specific goal, when you compare it to trying to understand their attitude, life style and financial habits. Numbers are numbers and numbers dont lie.

For instance, all else being equal, if you owe $20,000 at 18% interest, would you pay off your debt faster if you could borrow $20,000 from your 401k at 5% interest?  The answer is yes you would.

I have seen some argue that you lose out on the opportunity cost of the investment when you take money out of your 401k.  To that I say yes, but you also gain the fact that your money is not at risk either. I bet there are a lot of people who borrowed money from their 401k in 2007 that were awfully glad they did by the time 2009 came around because that $20k in 2007 would have only been about $10k in 2009.

However, likewise if you borrowed from your 401k in 2009 you potentially missed out on some great growth to the present. The point is that nobody can predict the stock market and it is true that maybe you lose out on growth and maybe you gain by not taking a big loss. It is something to consider for sure, but borrowing from your 401k doesnt always mean you will lose out on growth.

What do the numbers say?

I might ruffle some feathers with this one, but I would advance the argument that all else being equal. odds are, you have a bigger chance at coming out ahead overall if you borrow the money from the 401k than if you dont.

Lets use the $20k example. I am going to simplify this and only use 1 year simply to explain the concept of why the numbers say to borrow.

Option 1 Do not borrow from the 401k to pay credit cards.

a. Stock market goes up 10%.

2. You lose $3,600 on the interest you paid to your credit cards. (rounded for simplification)

3. Total loss is $1,600.

b. Stock market goes down 10%.

1. You lose $2,000 on your investment.

2. You lose $3,600 on the interest you paid to your credit cards. (rounded for simplification)

3. Total loss is $5,600.

Option 2 using the 401k to pay off debt.

a. Stock market goes up 10%.

1. You earn $0.00 on your investment.

2. You lose $0.00 on the interest you paid to your credit cards. (The 5% interest you pay to your 401K loan goes back to you)

3. Total loss is $0.00.

b. Stock market goes down 10%.

1. You lose $0.00 on your investment.

2. You lose $0.00 on the interest you paid to your credit cards. (The 5% interest you pay to your 401K loan goes back to you)

3. Total loss is $0.00.

Now looking at those numbers, I would say borrowing is the least expensive way to go unless the stock market gains more than 18%. Keep in mind that the opportunity cost of not borrowing the money means that you are still paying 18% interest. So when evaluating whether or not to borrow money, the odds are that your 401k is not going to return 18% plus gains year over year and the numbers are saying to borrow if you have already explored and exhausted other potential options.

So you are saying that I should borrow from my 401k to pay credit cards?

No, what I am saying is that there are a lot of factors to consider and whether or not you should be using a 401k to pay off debt depends on your specific circumstances.  In some cases it makes a great deal of financial sense to borrow from your 401k, assuming you have identified and corrected the attitudes and habits that put you in a financial situation to have to even consider borrowing from your 401k to pay off your credit cards.