Taking out a 401(k) loan can sometimes be a very good idea. While that statement might sound like blasphemy considering the frequent warnings from personal finance experts about the dangers of borrowing money from your retirement accounts, it can actually be a smart decision, as long as know what you’re getting into.
As a new paper from the Michigan Retirement Research Center points out, using 401(k) loans to pay off high-interest rate credit card debt can save money. And if more people felt comfortable using their 401(k) loans to spot themselves cash when they needed it, then they might be more likely to ramp up their savings rate, since they would know they could access the cash if necessary.
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Zachary Fruhling, 32, a philosophy PhD candidate at the University of California, Santa Cruz and founder of seemegetrich.com, recently used a 401(k) loan to do just that. “I had been struggling for some time to pay off my remaining credit card debt,” which came to about $9,000 at its peak, he says. He had been paying it off gradually, but when it came down to the final $2,000, he hit a wall. “To break the cycle, I decided to take out a 401(k) loan to pay of the remaining balance and automate the payments for the 401(k) loan to be deducted right from my paycheck,” he says.
Here’s why the decision was a good one:
Fruhling had a plan, and implemented it:
“With the 401(k) loan, I was able to pay off the credit card debt in one lump sum and leave it to automatic paycheck deductions to pay back the balance of the 401(k) loan, and at a lower interest rate at that,” he explains. Because he had a specific goal and then a plan for repaying the 401(k) loan, he lowered his risk of allowing his debt to continue to grow. Setting up an automated saving system helped guarantee that he stuck to the plan.
He had income stability.
One of the biggest risks with 401(k) loans is that if you leave your job (or get unexpectedly laid-off), you have to repay the loan quickly, usually within 60 days. Fruhling’s student status meant he could be relatively confident that his income wasn’t about to undergo any major changes.
He knew he could pay the loan back promptly.
While he hasn’t finished repaying the loan completely, he’s making steady progress through his automated payment system. “I have better peace of mind knowing that my credit card balance is completely paid off. Instead of worrying about credit card payments, I can now focus on the things that really matter,” says Fruhling. It’s important to put the money back in your account as soon as possible—and to continue contributing to your retirement savings even while repaying the loan—so you keep your money in the market. One of the biggest costs of 401(k) loans comes from missing out on the market gains while you’re money is out of the market.
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He knew the rules.
People also can get tripped up navigating company policies about retirement loans. Companies vary in how much they charge, interest rates, and repayment rules. Make sure you know what you’re getting into before taking out the loan.
He was trading expensive debt for cheaper debt.
Even the strictest advisors acknowledge a handful of scenarios when it makes sense to tap into a 401(k) loan. Averting life crises and paying off high-interest rate debt are among them. Not among them: Using a loan to fund a lifestyle you can’t really afford.
The bottom line: Don’t assume a 401(k) loan is always a bad idea. As Fruhling says, “In my case, it was a very good decision.”
Kimberly Palmer is the author of the new book Generation Earn: The Young Professional’s Guide to Spending, Investing, and Giving Back.