Does borrowing from my 401(k) make sense in my specific circumstance?

Question

I know the standard answer and understand that I will be losing out on that compound interest, but I am young and only need to borrow a few thousand. here are some more details:

• Need to borrow $6500 to pay off a car and two student loans ($300/month in payments combined)
• I am 22 and work full time, making about $70K annually
• I contribute 8% of my income with a 4% company match
• I increase that by 2% every year
• The loan would be over 48 months ($140/month)
• I live very frugally and have almost no discretionary spending that can be cut (don't eat out all the time, no gym membership/ Netflix/ Apple music etc.) I'm cash-poor: 90% of my salary is going to mortgage, groceries, students loans, car payment, newborn baby medical expenses, and commute.
• These are not my only debts, just the ones I am seeking to pay off in the short term. I work two jobs, one full and one part time. I started a business, and my wife has two jobs. Working more is not a good answer to the original question.

It seems to me that I would be reducing middle to high interest debt while also saving myself $150 per month.

Loans:

• Student loan 1: $1200 @ 5%
• Student loan 2: $1100 @ 4.25%
• Car Loan: $4000 @ 6%

Answer 1

Your comment regarding your existing finances is very relevant and helpful. You need to understand that generally in personal finance circles, when a strong earning 22 year-old is looking for a loan it's usually a gross spending problem. Their car costs $1,000 /month and their bar tabs are adding up so the only logical thing to do is get a loan. Most 22-year-olds don't have a mortgage soaking up their income, or a newborn.

With all of this in mind I essentially agree with DStanley and, personally, and many people here would probably disagree, I'd stop the 401(K) contribution and use that money to pay the debt. You're still very young from a retirement standpoint, let the current balance ride and forego the match until the debt is paid. I think this is more about being debt free at 22 quickly than it's about how much marginal money could be saved via 401(k) or personal loan or this strategy or that strategy. I think at your age, you'll benefit greatly from simply being debt free.

There are other very good answers on this site and other places regarding the pitfalls of a 401(k) loan. The most serious of which is that you have an extremely limited time to pay the entire loan upon leaving the company. Failure to repay in that situation incurs tax liability and penalties.

From my quick math, assuming your contribution is 8% of $70,000 /year, you're contributing something in the neighborhood of $460/month to your 401(k). If you stopped contributing you'd probably take home a high $300 number net of taxes. It'll take around 20 months to pay the loan off using this contribution money without considering your existing payments, in total you're probably looking at closer to 15 months. You'll give up something in the neighborhood of $3,500 in match funds over the repayment time.

But again, you're 22, you'll resume your contributions at 24; still WAY ahead of most people from a retirement savings standpoint. I don't think my first retirement dollar was contributed until I was about 29. Sure, retirement savings is important, but if you've already started at age 22 you're probably going to end up way ahead of most either way. When you're 60 you're probably not going to bemoan giving up a few grand of employer match in your 20s.

That's what I would do.

Edit:

I actually like stannius's suggestion in the comments below. IF there's enough vested in your plan that is also available for withdrawal that you could just scoop $6,500 out of your 401(k) net of the 10% penalty and federal and state taxes (which would be on the full amount) to pay the debt, I'd consider that instead of stopping the prospective contributions. That way you could continue your contributions and receive the match contributions on a prospective basis. I doubt this is a legitimate option because it's very common for employers to restrict or forbid withdrawal of employee and/or employer contributions made during your employment, but it would be worth looking in to.

Answer 2

The set of circumstances that 401k loans make sense, are very small. As you would expect yours is not one of them.

You make 70K per year and need 6500. Interest rate is not your problem, budgeting is the problem. Pay this off in three months not the 48 you are proposing.

Why is borrowing from your 401K a bad idea, especially in this case?

1. You have no float. If you lose your job, either by choice or not, you will owe the loan balance within 60 days. Where is that money going to come from? Remember you lost your main source of income. If you don't pay it back you will owe the irs the taxes on that money plus 10% penalty. This is akin to consolidating your debt at 30-45% interest. Dumb idea.
2. You kick the can down the road. Rather than have this problem for a shorter time period you now have a similar problem for 4 years. Why in the world would you do this to yourself?
3. Most consolidation schemes fail. Because you don't learn how to budget or live below your means, it is likely that the $150 will just find its way in new debt. This compounds the problem.

Look, been there done that, been the over spender. The sooner that you learn how to handle your money the better. I was in my 40s when I learned, if you can do this now you can be really wealthy by the time you get to be my age.

Dream a bit. How much margin would you have in your life if you were able to pay this off in 3 months? How much better would your life be? Go forth and do great things. I believe in you.

Answer 3

I completely agree with Pete that a 401(k) loan is not the answer, but I have an alternate proposal:

Reduce your 401(k) contribution down to the 4% that you get a match on. If you are cash poor now and have debts to be cleaned up, those need to be addressed before retirement savings. You'll have plenty of time to make up the lost savings after you get the debts paid off.

If your company matches 50% (meaning you have to contribute 8% to get the 4% match), then consider temporarily stopping your 401(k) altogether. A 100% match is very hard to give up, but a 50% match is less difficult. You have plenty of years left ahead of you to make up the lost match. Plus, the pain of knowing you're leaving money on the table will incentivize you to get the loans paid as quickly as possible.

It seems to me that I would be reducing middle to high interest debt while also saving myself $150 per month.

No, you'd be deferring $150 per month for an additional two years, and not reducing debt at all, just moving it to a different lender.

Interest rate is not your problem. Right now you're paying less than $30 per month in interest on these 3 loans and about $270 in principal, and at the current rate should have them paid off in about 2 years. You're wanting to extend these loans to 4 years by borrowing from your retirement savings.

I would buckle down, reduce expenses wherever possible (cable? cell phone? coffee? movies? restaurants?) until you get these debts paid off. You make $70,000 per year, or almost $6,000 per month. I bet if you try hard enough you can come up with $1,100 fairly quickly. Then the next $1,200 should come twice as fast. Then attack the next $4,000.

(You can argue whether the $1,200 should come first because of the interest rate, but in the end it doesn't matter - either one should be paid off very quickly, so the interest saved is negligible)

Maybe you can get one of them paid off, get yourself some breathing room, then loosen up a little bit, but extending the pain for an additional two years is not wise.

Some more drastic measures:

• Sell the car, pay off the loan and get a cheaper car with cash
• Find other stuff to sell
• Move to cheaper housing
• Get another job

Answer 4

I see you've marked an answer as accepted but I MUST tell you that STOPPING your 401k contribution all together is a bad idea.

Your company match is 100% rate of return(or 50% depending on structure). I don't care what market you look at, or how bad a loan you take out, you will not receive 100% rate of return, or be charged 100% interest.

Further, taking out a loan against your 401k effectively does two things: It is a loan that must be repaid according to the terms of your 401k AND in every 401k I've ever encountered, you cannot make contributions to the 401k until the loan is repaid. This in effect stops your contributions, and will almost certainly save you very little on your interest rates on your current loans.

I have 4 potential solutions that may help achieve your goal without sacrificing your 401k match and transferring the debt from one lender to another, but they are conditional.

Is your company match 100% up to 4% of your salary, or 50% of your contribution (up to a limit you have not yet reached)?

This is important. If it is 100% up to 4%, stop committing the additional 4% and use that to pay down your debt...and after ward set up that 4% as auto pay into an IRA, not into the 401k. An IRA will make you more money because YOU have control over its management, not your employer.

If it is 50% match, contribute until the match is met because you cannot get 50% rate of return anywhere, then take your additional monies and get an IRA. As far as your debt, in this scenario simply suck it up and pay it as is. You will lose far more than you gain by stopping your contributions.

If you simply must reduce your expenses by 150$ month try refinancing the mortgage and rolling the 6500$ into it. If you get a big enough drop in the interest rate you could still end up paying less. OR If you cannot make the gain there, try snowballing the three payments. You do this by calling your student loan vendor and telling them you need to make much smaller payments, like even zero depending on the type of loan. Then take ALL of the money you are currently spending on the 3 loans and put into the car payment. When it's gone, roll the whole thing into the higher interest student loan, then finally roll it all into the last student loan. You'll pay it off faster, and student loans have lots of laws and regulations regarding working with payers to keep them paying something without breaking them.

WHATEVER YOU DO, DO NOT STOP YOUR CONTRIBUTIONS. 50% OR 100%, THAT MONEY IS GUARANTEED AT A HIGHER RATE OF RETURN THAN YOU CAN GET ANYWHERE, ESPECIALLY GUARANTEED.

Answer 5

You're getting great wisdom and options.

Establishing your actionable path will require the details that only you know, such as how much is actually in each paycheck (and how much tax is withheld), how much do you spend each month (and yearly expenses too), how much spending can you actually cut or replace, how comfortable are you with considering (or not considering) unexpected/emergency spending. You mentioned you were cash-poor, but only you know what your current account balances are, which will affect your actions and priorities. Btw, interestingly, your "increase 401k contributions by 2% each year" will need to end before hitting the $18K contribution limit.

I took some time and added the details you posted into a cash-flow program to see your scenario over the next few years. There isn't a "401k loan" activity in this program yet, so I build the scenario from other simple activities. You seem financially minded enough to continue modeling on your own.

I'm posting the more difficult one for you (borrow from 401k), but you'll have to input your actual balances, paycheck and spending. My spending assumptions must be low, and I entered $70K as "take-home," so the model looks like you've got lots of cash. If you choose to play with it, then consider modeling some other scenarios from the advice in the other posts.

Here's the "Borrow $6500 from 401k" scenario model at Whatll.Be: https://whatll.be/d1x1ndp26i/2

To me, it's all about trying the scenarios and see which one seems to work with all of the details. The trick is knowing what scenarios to try, and how to model them.

Full disclosure: I needed to do similar planning, so I wrote Whatll.Be and I now share it with other people. It's in beta, so I'm testing it with scenarios like yours.

(Notice most of the extra activity occurs on 2018-Jan-01)

Answer 6

Since most of the answers are flawed in their logic, I decided to respond here.

1) "What if you lose your job, you can't pay back the loan" The point of the question was to reduce the amount paid per month. So obviously it would be easier to pay off the 401k loan rather than the 3 separate loans that are in place now. Also it's stated in the question that there's a mortgage, a child with medical costs, a car loan, student loans, other debt. On the list of priorities the 401k loan does not make the top 10 concerns if they lost their job.

2) "Consider stopping the 401k contribution" This is such a terrible idea. If you make the full contribution to the 401k and then just withdraw from the 401k rather than getting a loan you only pay a 10% penalty tax. You still get 90% of the company match.

3) "You lose compound interest" While currently the interest you get on a 401k (depending on how that money is invested) is higher than the interest you pay on your loans (which means it would be advantageous to keep the loans and keep contributing to the 401k), it's very unreliable and might even go down.

I think you actually have a good case for getting a loan against the 401k if
a) You have your spending and budget under control
b) Your income is consistent
c) You are certain that the loan will be paid back.

My suggestion would be to take a loan against the 401k, but keep the current spending on the loans consistent. If you don't need the extra $150 per month, you really should try to pay off the loans as fast as you can. If you do need the $150 extra, you are lowering the mental threshold for getting more loans in the future.