From: mark0young@aol.com (Mark0Young)
Newsgroups: misc.invest.financial-plan
Subject: Re: 401k loan to pay off high credit cards?
Date: 1 Sep 2003 05:30:01 GMT
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In article <493706bc.0308311257.2e498883@posting.google.com>,
bmcpheeters@scene7.com (Brian McPheeters) writes:

>Any drawbacks to this?

There are several drawbacks I see:

1. Most important: have you fixed whatever it is that got you into serious
credit card debt? The track record for using "cheap" loans (401(k) loans, home
equity loans) to "pay off" credit card is very poor. One study done for the
FDIC showed that 70% of those who took a high Loan To Value loan were back in
credit card debt 1 year later. One site I frequent has a board on Credit Cards
and roughly the same ratio is mentioned there: the vast majority of the time
such loans just become enablers of getting further into debt; it is only when
someone had a specific debt elimination plan and the new loan was part of that
plan (i.e., plan to pay off that loan) that it usually turned out to be good
instead of bad.

2. Most (not all) 401(k) plans require that the loan be paid off in short order
after separation from service (typically 30 days from date of separation), or
the loan balance would be deemed an unqualified distribution, subject to both
income taxes and 10% federal penalty for early withdrawal (plus any state
income tax and penalty). Separation from service could be from any cause,
including layoff or moving to a better job at another employer. The worst case
would be if one is layed off (no job = no new loans), the cards are maxed out,
so one cannot pay back the 401(k) loan.

3. While this is a Loan in name, it is actually a withdrawal with a scheduled
replacement. That means the amount "borrowed" is removed from the 401(k) plan
and thus cannot participate in any movement of the underlying investments until
the money is placed back into the account. Since you state you would be paying
4%, probably most of that 4% interest will go into the 401(k) account, which is
probably less than a well-diversified portfolio would earn over the long run.

4. You have to check what limitations you have while you have a 401(k) loan
outstanding. Does your plan lock you into a specific payback schedule that
doesn't allow additional payments unless paying it off in full? Does it prevent
you from contributing to the 401(k) until the loan is paid back, and would that
prevent you from getting an employer match for that time? Would you be unable
to take out another 401(k) loan until that one is paid off? (Why would anyone
want to take out a 401(k) loan for other purposes? Think down payment for a
home purchase, or replace a damaged roof. Not that I advocate using 401(k)
loans for this purpose, but there can be times when one must make use of
whatever resources one has available, so it is prudent to keep the major doors
open, if possible.) Different 401(k) plans have different restrictions.

A 401(k) loan is a tool. It can be a very dangerous tool (financially
speaking), or it could be the perfect fit for your situation. In any case, I
would recommend that you consider the alternatives (e.g., possibly a credit
card with a great promotional rate), and consider the tradeoffs of the options
available to you at this time.

Mark A. Young