401k Loan or Debt Consolidation (What’s the Best Way Out of a Bad Situation?)

Have you ever taken a 401k loan?

401k loans are a very difficult personal decision.

As many as 20% of participants in your average 401k plan have taken out a loan.

I almost took out a 401k loan back in 2007 when I was scraping together a down payment on our first home.

Ultimately though, I think too many people borrow from their 401k and other things should be done first before resorting to the 401k loan. Here’s a recent question I received from a reader on the subject:

Is it more cost effective to take loans from your 401k and then pay yourself back? Or should other forms of loans be considered, eg., debt consolidation (using a personal loan), to condense debt and ultimately be debt free?

First, debt consolidation does not “condense” debt. You have the same amount of debt before and after debt consolidation. All that changes is the number of loans you have and the total in monthly payments that you have to make.

Consolidation is not a solution to get rid of debt. It only changes the form of the debt. To be clear, I do support some forms of consolidation (mainly credit card balance transfers) as a smart strategy as part of your overall plan to get out of debt. But make no mistake, consolidation isn’t a solution in and of itself.

Risk and the 401k Loan Interest Rate

As to whether it’s more cost effective to do a 401k loan, yes, it may be more cost effective. The interest you pay back on your 401k loan is paid back into your 401k account. You are paying yourself the interest. With other loans, the interest is going to the lender.

So, the 401k loan will almost always beat any other type of loan when it comes to being cost-effective.

But I see the 401k loan as much more risky than other loan types. There are many reasons not to borrow from your 401k. But one of the biggest reasons not to borrow is what happens when you lose your job.

Most employers are going to require you to pay back your 401k loan within 60 days. Chances are, if you’re taking out a 401k loan, you aren’t going to be able to pay it off in 60 days. What will happen then is you will default and the money you owe will be considered an early withdrawal.

An early withdrawal from a 401k means you’ll have to pay taxes and a 10% penalty for not keeping your funds in your 401k until you retire. It’s just not worth the risk to borrow from your 401k.

So What’s Better than a 401k Loan?

When it comes to getting rid of debt, nothing compares to an actual plan to be debt free. Do you have a plan in place? Meaning, have you listed all of your debts and established a schedule to aggressively repay them? Have you made your plan ultra aggressive by reducing your expenses to the minimums?

Another loan isn’t a solution to the problem. No matter the type of loan. So unless you have a plan in place first, you aren’t going to get anywhere with another loan, regardless of the type.

If you do have that plan in place, and you see yourself as being a year or two away from completely debt free, then a strategy to supplement your debt reduction plan could be to shift some of your debt over to a lower interest payment.

Right now you should be able to get a promotional 0% interest rate from a credit card company or a low interest rate from a peer lending company. That’s about the only two places I would say to go if you’re on your way out of debt and just want a little kicker to help you get there faster.

If your intention for taking out a 401k loan isn’t debt reduction, but a house down payment, then I would also advise against it. Take an extra few months to save up the money. Prove it to yourself that you’re ready for that home.

What’s your opinion of the 401k loan? Better than other forms of borrowing?