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High interest-rate credit card debt is an exercise in sheer frustration. The balances decrease at a snail’s pace, if at all. Years go by and yet the debt is still staggering. Ultimately, you can pay five times the value of your initial purchases. That’s a fantastic deal for your creditor, but not a very good one for you or your family. Understandably, many people are tempted to pay this debt off by borrowing against a 401(k). It certainly is a very appealing option, but it does have ramifications. Here’s what you need to consider:
Your Credit Card vs. 401(k)
When it comes to borrowing against your 401(k), you can usually do so at two percentage points above prime (these days, that’s about 6%).
Keep in mind, though, that unless the loan is for the purchase of a home, the debt must be repaid within five years. If you owe $10,000 and borrow that amount at 6%, you would need to pay $178 per month to be finished within the required period of time. Now, compare that with your credit card. Let’s say your interest rate is 20%. For you to be free and clear of that debt within that same time frame, your payment would be $265 per month. At this point, the 401(k) is the better deal, however, typically a 401(k) loan cannot be larger than $50,000 or half the balance in your 401(k) account, whichever is less.
More important, if you lose your job while the loan is outstanding, your former employer will most likely require that the remaining balance be paid within a short period of time (typically within 60 days of your departure date). If you are unable to do that, then the tax penalties are harsh: the IRS will consider the balance as a distribution subject to income tax, and if you’re under age 59, and not retired, you will be hit with an additional 10% penalty.
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Before you risk shortchanging your future, consider every alternative. First, try to get a lower interest rate on your card. A simple phone call to your creditor might accomplish this for you. If you are turned down initially, pay consistently, pay more than the minimum and try again a few months later. Another good option is to simply determine how much it would cost each month to pay off your debt in less than five years. Commit yourself to making those payments by having that amount automatically deducted from your checking account. This way, you budget for it and you won’t spend it elsewhere. A balance transfer seems to be a great choice on the surface. However, you should undertake such a transaction with extreme caution, or it can turn into a very costly mistake.
Finally, no matter which approach you take, resolve to budget wisely, use cash (debit cards will do just as well) and put credit card spending behind you.
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