How to Use Your 401(k) to Consolidate Your Own Debt

If you have outstanding loans, you may have wondered whether you could use your 401(k) to consolidate your debt. It may be possible, but there are pluses and minuses to consider.

A 401(k) is a retirement savings program offered to employees by their employer. Employees contribute an amount of their salary annually, up to statutory limits. This is invested in a tax-efficient manner along with contributions from the employer. The employee then is expected to continue contributing until age 65, when the plan matures and withdrawals can be made.

Consumers with a lot of personal debt may find it tempting to consolidate their debt into one lump amount. Consolidation offers a number of advantages. Multiple payments can be combined into a single repayment plan, which is far easier to manage on a monthly basis. Consolidated debt also can reduce the total payment each month, making it more affordable for the individual to repay.

If you have a poor credit history, or if you already have a number of loans, straightforward consolidation may not be an option for you. In that case, consolidating debt with your 401(k) is one way to approach the problem.

How it works

Money that has been paid into a 401(k) plan can be loaned back to the individual at a moderately low rate of interest. You are limited, though, to the amount you can borrow. Individuals can borrow only up to 50 percent of the total value of their plan or $50,000, whichever is greater. Repayments must be made within five years, and the loan is only valid while you remain employed with the same employer.

The advantages

Obtaining a loan through your 401(k) is quick and easy. In most cases, a simple application form is all that's required. In some cases, providers can handle the whole process via a telephone call.

The interest rate on these loans is comparably low, which means that you are likely to save money when compared to other credit agreements. The rate is normally a couple of points above the prime rate, and is usually the lowest unsecured loan rate available. If you have problems with your credit history, they will not affect these loans. As long as the funds are available, applicants are always approved.

The disadvantages

Loans made against your 401(k) plan will eat into the earnings of the plan. A loan of $25,000 paid back over five years, with no other contributions in this time, will mean that the final pay-out could be reduced by thousands of dollars that would otherwise have been earned in interest. Money that normally would be in the plan accruing a significant value is now lost.

Taxes play a role, too. Money saved in a 401(k) normally would be paid out at retirement tax-free. By loaning yourself the funds, however, you effectively erode this benefit-because the interest on the loan is not tax deductible. The most serious risk, however, comes if you lose your job during the loan term. If this happens, the balance of the loan will need to be repaid, along with a 10 percent penalty on the balance.

Your 401(k) may represent a definite opportunity to consolidate your personal debt, under certain circumstances. There are both advantages and disadvantages to this kind of debt consolidation. The cost savings could be eroded if you lose your job, so consider all alternatives carefully.

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