I have a student loan that has 6.5% interest (highest rate of many) and would be able to repay it if I took a loan on my 401k. I know the basic trade-off is that my money may do better in the 401k than 6.5%, but what other considerations should I make?
Here are some other things to consider:
- You must pay the 401K loan back over a maximum of 5 years. Student loans are usually longer than this, so make sure your cash-flow can actually support the new payment timeline.
- The repayment of a 401K loan gets deducted directly from your paycheck, which may decrease the take-home pay you're expecting. Not a deal-breaker, just something to be aware of.
- Many 401K plans won't let you make any further 401K contributions until you've repaid the loan. You'll miss out on some valuable tax-free investing because of that, which may include your employers match. There is a large opportunity cost to borrowing this money.
- Your long-term returns in your 401K may be lowered because you'll be breaking the dollar cost average of your contributions.
- You still have to pay interest back to your 401K account on the money borrowed. This is usually prime + one or two percent. With prime currently at 3.25%, do the math and make sure it makes sense in terms of the interest rates.
If you leave your job (or lose it) the loan is due on separation. You'll pay tax and a10% penalty.
Don't do it! The penalty and repayment requirements of the 401K will likely be more of a headache than the student loan payments. Just pay off the student loans the normal way, or in larger chunks, if you can. Student loans often have lower interest rates than other loans.
Think of your 401k as your long term savings. Don't rob your long-term self to pay the student loans.