Paying off debt with a 401(k) loan

(Money Magazine) -- Question: Should I borrow from my 401(k) to pay off debt? -- Verlyn Regehr, Denver, Colorado

Answer: If nothing else, the financial crisis changed our attitudes (at least temporarily) toward debt. Before the meltdown, borrowing was a pure plus. It allowed you to have a bigger house, a bigger car, a bigger life. Some people even believed, to their subsequent dismay, borrowing was a sure-fire way to bigger investment returns.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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After the crisis, we're more likely to think of debt like the albatross in Samuel Taylor Coleridge's Rime of the Ancient Mariner, something that weighs us down that we're desperate to be free of.

According to a recent TD Ameritrade survey, 39% of Americans now define financial success as being debt free.

So I understand -- and generally applaud -- your urge to pay off debt.

But let's be clear. By borrowing from your 401(k), you won't actually be paying off debt in the sense of eliminating it. You'll be replacing your existing debt with another loan.

So the real issue is whether it makes sense to transfer your debt to your 401(k).

As a rule, I don't like to encourage people to think of their 401(k) as a piggybank to dip into or borrow from. Using it that way can conflict with and undermine its true purpose, which is to provide you with a nest egg to support you in retirement.

That said, there are circumstances in which a 401(k) loan may be better than some of the alternatives. But even in those cases, it's important that you understand the risks of tapping your 401(k) for a loan.

If you're paying a high interest rate on your current loan (or loans, as the case may be), then you may very well be able to cut your interest costs by paying them off with proceeds from a 401(k) loan.

Terms can vary from one plan to another, so you'll want to check out what conditions yours sets (assuming your plan allows them, as most do). Typically, 401(k) participants can borrow the lesser of 50% of their account balance or $50,000 and repay it via payroll deductions over a five-year term at a rate of one percentage point above prime. That would put the interest rate today at 4.25%.

Given that attractive rate, borrowing from your 401(k) may seem like a no brainer. But before signing on, there are number of things you need to consider.

Perhaps the most significant issue is that if you switch jobs or are laid off from your current position, most employers require that you repay the loan within 60 days. Fail to do that, and the outstanding balance is considered a distribution on which you'll owe tax and, if you're under 55, a 10% penalty.

Another downside is that some plans don't allow you to make contributions to your 401(k) while a loan is outstanding. That can have two unpleasant effects. One is that by missing out on new contributions while repaying the loan you'll end up with a lower account balance at retirement than you would otherwise have had. The other is that, without new 401(k) contributions lowering your taxable income, your current tax bill is likely to go up.

Despite these caveats, you may still see a 401(k) loan as a better deal than the loan arrangement you have now. Fine, but before you borrow from your 401(k), you still want to see if there are other comparable or better options.

One possibility is finding another loan that's as or nearly attractive as what you'll get from your 401(k). Granted, that's a tall order if your 401(k) is letting you borrow at prime plus one. But you might be able to come close with a home equity line of credit.

The rate you'll get will depend on a number of factors, ranging from your credit score, the size of the loan and how eager a bank is to lend. On average, though, home equity lines were charging 4.8% or 5.13%, depending on the amount borrowed. And with a little shopping around, you might be able to do better (although you'll also have to take a home equity line's other fees into account when assessing its cost).

Even if a home equity line of credit doesn't match or beat a 401(k) loan on rate alone, it has other advantages that might make it a more appealing choice. One significant difference is that, unlike interest on 401(k) loans, interest on a home equity line of credit is usually tax deductible. Depending on your tax rate, that break could make the home equity line's after-tax rate comparable to or even lower than the 401(k)'s rate.

And while we're on the subject of taxes, remember this: not only do you not get to deduct interest on a 401(k) loan, you actually end up paying tax twice on the money you use to pay interest on the loan -- once before you make the loan payment and again when you eventually make withdrawals from your 401(k).

And while perhaps not a huge advantage, you also typically get more flexible repayment terms with home equity lines.

Given all this, I think it's certainly possible that, unless the 401(k) rate is significantly lower, someone might prefer the home equity line of credit to a 401(k) loan, if for no other reason than you don't have to worry about a big repayment in the event of a job change or loss.

Bottom line: If I were you, I'd first try to find a way to get out of debt without raiding your 401(k). That could mean stepping up payments on the debt you already have or replacing your current debt with a home equity line or other loan that has a lower rate of interest. Better yet, you could do both.

But if you decide to go ahead and borrow from your 401(k), then at the very least consider how you'll handle the situation should you leave your job and be faced with having to repay the loan much faster than you'd anticipated.