Recently, I received an email from Chris who was interested in my opinion on taking out a 401k loan to pay off his student debt.
Did you ever consider leveraging your 401k to try to clobber debt faster?
I do not mean withdrawing funds from the 401k and incurring the penalty and tax hit, I mean borrowing from it and then paying it back and paying yourself the interest rather than Navient.
All the articles I have read say “don't touch your 401k” but they are ALWAYS referring to withdrawing the funds rather than taking a loan.
I can take a loan out of my 401k up to $50,000 and I can set the repayment length to whatever monthly payment that I can afford. I want to take this $50,000 and payoff my loans in one gratifying check then use the money I was paying towards my student loan principal and interest (about $2,000 a month) to repay my 401k.
There are some risks to this like if I lose my job I would need to repay that debt immediately but the probability of that is very low. My goal is to finish paying off my loans by 2019 (10 years after graduating college) and I am on pace to do that with either method but I think the 401k loan would save me a ton of money over just repaying the lender. This technique could be done with a HELOC too but I think that is much more dangerous.
I think it would be awesome to hear about the pros and cons, if not I would love to just hear your thoughts on the matter.
I am a huge fan, keep up the good work!
Thank you so much for reaching out, Chris. I'm glad to hear that you've been enjoying the blog and the podcast.
As far as taking a 401k loan, I was actually thinking about doing this earlier this year for investing in our first rental property. The more I've read and investigated, the process just didn't work for a conservative guy like me.
Here's why I didn't go for the 401k loan:
1. Potential Job Loss
I'm not sure how it would work with your employer, but with mine I would have to pay back all of the 401k loan money within 30-90 days if I lose my job, take a new one or leave the company for any other reason.
I found this commentary (below) on Reddit. An HR manager described some tough situations they experienced when employee's 401k loans came due unexpectedly:
“As someone who worked in HR/Benefits for many years, the main reason I always see and advise against is that (1) no job is stable and (2) it's not just laying off/firing that makes the loan come due. What if you get an amazing opportunity elsewhere and quit? Well that loan is still due … I've had people crying on the phone because they didn't understand the terms.”
You could protect yourself from this situation by saving up enough liquid cash for that emergency. If you did that though, you might as well just use the cash you saved up to pay off the student loans.
2. Lose Out on Crucial Retirement Returns
During the borrowing period, my 401k account would have been severely depleted. I have around $100k saved up right now in my 401k. If I took out $50,000 (like you're considering), the power of my compound interest wouldn't be so powerful.
I want to leave those retirement funds in there to build over time.
3. The Tax Man Can Bite Ya
Let's say, my family comes into hard times and I'm unable to make the consistent re-payments required on the 401k loan. Uh oh.
The entire amount that I'm yet to pay would become taxable. And Chris, since you and I are both under 59 1/2, we'd also be subject to the 10% penalty as well.
In my situation, if we're using the 401k loan for a rental property, we would experience double taxation. The principal and interest we'd pay back on the 401k loan would be after tax money. This means that when we withdraw funds from our 401k in retirement we would be taxed again on that principal and interest!
Two points for Uncle Sam and zero points for our family.
Chris, this wouldn’t be exactly the same in your situation given that your student loan payments are essentially after tax money, but this is a reason for people to consider when thinking about 401k loans.
Options Outside of the 401k Loan
You have to do what's right for your personal situation, Chris. If you think it's worth the job risk and loss of returns, then you do what you have to do. I wouldn't suggest it though. That’s because I’m more of a conservative guy I guess.
Instead, I'd like to suggest some other ways to eliminate this $50k in student loan debt.
Increase Your Income
- Full Time Job: If you've been busting your butt at work, it may be time to ask for a raise that you deserve.
- Side Job: It may be time to start a side hustle that brings in some extra cash. Who knows? It could lead you to some amazing places.
- Selling Stuff: Do you have some “stuff” around the house that you could sell on Facebook Marketplace or Craigslist? Easy and quick cash.
4. Skills: Do you or your wife have a skill that could get you some cash?
5. Etsy: Are you crafty? I recently interviewed someone who's making some solid dough on Etsy.
(Related Show: Creating Multiple Income Streams to Eliminate $100k in Debt)
Reduce Your Expenses
- Refinancing Student Loans: Have you looked at refinancing your student loans lately to see if you could get the interest rate down? Student Loan Hero is an option that I've recently learned about that compares options from multiple companies on your behalf.
- Cut Cable: If you still have cable, we cut the cord a year ago and we don't miss it.
- Groceries: Nicole and I did some work on our grocery spending earlier this year and we saved almost $4k with the changes we made.
- Budget: Living on a monthly budget has been one of the major reasons my wife and I have been able to crush our debt. Mint has been our go-to, but Tiller is another great option for people who like spreadsheets.
The point of me throwing out these questions and suggestions is that I believe there are better options than the 401k loan.
Are they harder?
Oh yeah … but I'd hate to see you get stuck in a tough situation with the 401k loan if you lost your job.
I hope this helps, Chris.
Money Master of the Week
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Hi, that was a good read and it takes some serious planning and consideration whether to take it out 401k or not. I had to do this because I was also in a bind. But everyone’s situation is different. I was just glad that when I actually did took out the loan out (2x) I was able to pay it out within the time frame I’ve set my mind into it. It took a lot of planning and strategizing in paying it back. Since it involves automatic deductions from my paychecks plus I’ve added more when I was able to produce extra money from another side job and that helped speed up my repaying process without hurting my monthly budget. Now I’m debt free and been cash flowing. This time I’m starting to learn how to use those extra cash on my 401k and start diversifying to grow more than ever. Thanks for posting this!
I’m so glad to hear that this worked out okay for you. AND you had the discipline to pay it all back on time without incurring penalties. Congrats on the debt freedom! Now onto building major wealth!