Here’s Why a 401(k) Loan to Pay Off Debt Can Cost You a Massive Amount in Retirement

Over the years I’ve been asked time and time again about if a 401(k) loan is a good idea to take out to pay off debt. I typically say the same thing, in most cases it makes no sense to touch the money in the 401(k) that is protected from creditors if you can qualify for a chapter 7 bankruptcy. Even a chapter 13 bankruptcy can make sense to protect that investment.

Over the past month I’ve been working with a couple of CFPs and an actuary and statistician to come up with a look at this situation to see if my hypothesis is true. My hunch has always been that in taking out the 401(k) loan, while the interest paid is low, the value of the investment that would have been earned on the loan amount is lost and if the 401(k) had been left untouched, more money would be available when people need it most in retirement.

What started as a simple calculator has evolved into a much more complex tool that we hope to make available as an online tool for people to use. Feedback from friends and peers on this project has been invaluable. But two things are apparent now. First, that there are a lot of variables to consider. Second, nobody is going to be average. Every situation will be different.

But let’s look at what we can safely calculate given some near and far term assumptions. In this case we have an example of an average person that some have given me that typifies their real world experience with those borrowing from their 401(k) to pay off debt.

So let me lay the groundwork with the factors used for this calculation:

  • Current age: 43
  • Retirement age when they will draw from 401(k): 70
  • Current credit card balance: $20,000
  • Average credit card interest rate: 16%
  • Credit card minimum payment $400
  • Currently investing in 401(k) monthly: $300
  • Employer matching contribution: $30
  • 401(k) loan interest rate: 5%
  • Length of 401(k) loan: 36 months
  • 401(k) loan payment per month: $300
  • Expected anual return of 401(k): 6%
  • 401(k) loan amount to settle debt: $10,000
  • Current 401(k) balance before loan: $80,000

We also assume that in both scenarios a portion of the money that was previously used for minimum credit card payments would be used to invest into the 401(k) for retirement. In this case the calculation is that 50% will be invested. With more money available through bankruptcy or settlement, people will naturally expand their lives for a bit more fun with that freed up money so it is unreasonable to expect that all of the previous minimum credit card payment would be invested.

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So, looking at all of that, here are the results:

  • If the 401(k) had been left alone and the debt had be resolved with bankruptcy the balance of the 401(k) at retirement would be $737,338.
  • If the 401(k) loan is taken to settle the debt the balance of the 401(k) at retirement would be $648,776.
The $10,000 401(k) loan at age 43 winds up costing $88,562 in retirement funds available at age 70.

There are a number of factors that can’t be included, such as the rate of future inflation, the variability of periodic additional investments, unemployment, etc. The purpose of the calculator is to give people a comparison of the cost of each scenario in order to compare the true impact of a 401(k) loan as compared to considering bankruptcy.

Those taking a loan could take the loan and then work hard to make much larger contributions to catch up to what the 401(k) balance would have been under the bankruptcy scenario.

So my point remains the same and it appears the hunch has been verified. The reality is that a 401(k) loan to pay off debt can actually cost many times over the amount of the loan when the money is needed in retirement. It’s not necessarily a reason to not take the loan but a point that consumers should be made aware and contemplate before a loan is blindly taken.

But Here’s What Surprising

If we make a lot of the same assumptions but take $20,000 out to pay off the entire credit card balance, the end result is not that much different.

  • Current age: 43
  • Retirement age when they will draw from 401(k): 70
  • Current credit card balance: $20,000
  • Average credit card interest rate: 16%
  • Credit card minimum payment $400
  • Currently investing in 401(k) monthly: $300
  • Employer matching contribution: $30
  • 401(k) loan interest rate: 5%
  • Length of 401(k) loan: 36 months
  • 401(k) loan payment per month: $599
  • Expected anual return of 401(k): 6%
  • 401(k) loan amount to payoff debt: $20,000
  • Current 401(k) balance before loan: $80,000
  • If the 401(k) had been left alone and the debt had be resolved with bankruptcy the balance of the 401(k) at retirement would be $737,338.
  • If the 401(k) loan is taken to pay off the credit card debt in full the balance of the 401(k) at retirement would be $648,225.

If the calculator is correct, this means that a 401(k) loan to pay off the debt in full would potentially have a much higher rate of return if the larger minimum loan payment is affordable. While it still costs a significant amount in retirement, the advantage of paying of the debts in full and preserving a good credit history and not closing those accounts may pay dividends in the future.

With a settlement approach there would most likely be notations on the credit report that the debt was settled and part of the balance was forgiven and if the consumer was not insolvent at the time they settled their debt, they may also owe income tax on the amount forgiven.

Every situation is different and there are a plethora of variables and factors that need to be accounted for but this at least gives us the grounds for a better discussion of these issues.


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35 thoughts on “Here’s Why a 401(k) Loan to Pay Off Debt Can Cost You a Massive Amount in Retirement”

  1. Am from Texas and going to retire from military (Jan 2013) Have problem with my personal loan taken some years back. Now cannot proceed with my retirement as they need a good credit report, and the bank does not want to issue unless I paid all interest (41K) Have paid the principal loan of 9K, need to take retirement fund to pay the interest of 41K. Please anyone can advice where or how to get a loan to settle my previous loan.

  2. You guys are out of your mind. Have you ever advised someone in a real situation. What happens to the person who takes a big loan and then gets laid off from their job? Huge potential negative tax consequences. 401(k) loan is hardly ever a good idea

  3. I couldn’t help but notice that you two are the only ones still defending/justifying convincing consumers to borrow funds from a retirement account even when proven wrong.  Let it go guys, the numbers dont lie.  Seems the only ones who benefit are those who profit from this advice.

    • “Seems the only ones who benefit are those who profit from this advice.”

      That is totally unnecessary. I have demonstrated in a variety of ways on how it can be beneficial to the consumer in these comments. How about you run those numbers before making such an uneducated and irresponsible comment? 

      Is a 401k loan logical in all situations? No

      Can a 401k loan be logical? Absolutely 

      What scares me the most is that people in my field don’t even understand how to identify when it is logical and instead peddle a long term approach that leads to long term credit destruction, possible lawsuits, interest, stress, and a less than 10% chance of being successful. 

      Help me understand that, will you please? 

      • Thats my point Jared, its never logical.  If the consumer’s situation worsens they have lost their retirement.  It has nothing to do with long term vs short term, its just too risky.

        Help me understand the logic of using retirement funds to pay off unsecured debt, in turn converting the debt to secured debt?  Call me illogical but that makes no sense to me. 

    • My position is that consumers should consider use of retirement funds for settlements only if they would otherwise be forced to declare BK under Chapter 13, and not if they are eligible for Chapter 7.

      When I asked Steve for clarification on Chapter 13, he replied: “The scenario this calculator was designed for is the 70% of bankruptcy filers that fall in the chapter 7 bucket.”

      By definition therefore, this calculator does not apply to most situations in which a 401k loan might actually make good business sense. We’re totally talking apples and oranges. Steve’s calculator demonstrates that apples are red. You, on the other hand, are saying it also proves that oranges are red. Time for that annual eye exam, my friend. 🙂

        •  Actually if you look at a case by case basis and have a full understanding of the consumers situation, mindset and what they are trying to accomplish, there are certainly times that it makes sense to use retirement funds to settle the debt.

          • You are right Damon, I’m sure on paper there are scenarios where it makes sense and it seems safe so maybe “not ever” is a bit absolute but from experience, all it takes is one bump in the road and repayments to the retirement account get pushed to the back burner and eventually never repaid. 

            If the risks are explained right, most would turn down the option.  

            Option 1: put your retirement account at risk for the 36 months it will take to repay AND keep your fingers crossed that your situation doesn’t worsen during that time. 

            Option 2: take 36 months to repay by settling one account at a time.  You will have to deal with creditor calls and the possibility of a lawsuit (attorney provided) – typical lawsuit settlements range from (30%-75%) and preserve your retirement account.  

            Option 3: File Bankruptcy and you still preserve your retirement account.  

            So I will withdraw my “not ever” comment but I stand firm on my position that consumers should not be solicited to use their retirement accounts to settle their unsecured debt.  

          • Just don’t forget about the consumers mindset. For many, dealing with collection calls and possible lawsuits for 3 years is very debilitating and stressful. So if a chapter 7 is not an option, most consumers would prefer to use the 401, settle quickly, and start rebuilding. Rather than drag out settlements.

          • I agree, that’s the occasional scenario where I’ve seen it.  In my experience when those consumers have had enough they tend to offer it up on their own.  I just dont think consumers should be solicited to tap into their retirement, that’s all, that’s been my argument all along.  

  4. Steve, as I read this post, I was reminded of an old joke told to me by my Economics 101 professor. Two economists are walking in the jungle. One of them falls into a deep pit trap. He’s not injured but the walls are smooth and too high to climb out. “Help!” he calls to his comrade above. “How do I get out of here?” The other economist smiles down at him and says, “First, we assume a ladder …” 🙂

    Consider the impact of altering a few of the base assumptions here. For example, people considering settlement are usually not continuing to fund their 401k accounts and have long since already stopped doing so; therefore no ongoing contribution and no employer match.

    Also, credit card APRs will not stay at 16% for long if the consumer has become unemployed and will soon be forced to default. Default rates of 30% are more likely to be the case for consumers headed toward the financial cliff.

    You appear to be assuming 2% minimum payments ($400 on $20k CC debt), where nowadays many creditors require 1% of principle balance plus finance charges, so more like 2.5% average these days, 3.0% in some cases.

    Further, many people have already hit their retirement accounts in order to stay afloat during a period of unemployment, and it’s therefore common to see people with far less in the 401k than they owe in total on credit card balances. So borrowing to pay the whole CC balance is not an option for them anyway, where borrowing for settlement might still make good sense.

    And of course, it should be a no-brainer that someone who qualifies for Ch. 7 BK should not borrow from protected retirement funds. Ch. 13 conditions, however, are a completely different story. I’d like to see this analysis compared to a “typical” Ch. 13 case where (say) 50-60% of the debt has to be repaid over a 60-month plan.

    • I agree there are a lot of variables in play here. The point of the calculator is to create an awareness of possible impact and a starting point for a conversation.

      I’m happy to adjust the variables for a different set of variables.

        • No you didn’t miss anything. The road to providing some basis for a calculation becomes a never ending project when you factor in every possible scenario. The scenario this calculator was designed for is the 70% of bankruptcy filers that fall in the chapter 7 bucket.

          Actually, forward looking calculations of all types will be erroneous with such long windows for changes to occur. The basis of this calculator is only for people to use it as a starting point for a conversation with a consumer or for someone to have this conversation with their debt relief company.

          As I have said all along, for those that have the cash to settle and where settlement makes sense, such as the chapter 13 scenario, it can be a perfectly reasonable and logical solution. 

          If someone wants to make that choice based on the facts of their situation, it’s their choice to make.

          The calculator is not designed to talk someone out of settling if that is their intention but to just be aware that a 401(k) loan can have longer term consequences. Informed consent protects both the debt relief company and the consumer.

          And this calculator is not designed for IRA withdrawals which would require a different set of assumptions like penalties for early withdrawal, etc. 

      • What does the calculator show under the following conditions?

        Current age: 43   
        Retirement age when they will draw from 401(k): 70   
        Current credit card balance: $20,000   
        Average credit card interest rate: 29%   
        Credit card minimum payment $500   
        Currently investing in 401(k) monthly: 0   
        Employer matching contribution: 0   
        401(k) loan interest rate: 5%   
        Length of 401(k) loan: 36 months   
        Expected annual return of 401(k): 6%   
        401(k) loan amount to settle debt: $8,000   
        Current 401(k) balance before loan: $20,000

        • Seen attached image. The calculator has been tweaked just a bit so that a percentage of what used to be the minimum credit card payment is added to investing to the 401(k) till retirement. 

          With BK – $433,408
          With Loan – $268,866

          You will see I had to put a minimum into the 401 and match.

  5. Here’s another scenario, and a more likely one for consumers that borrow from their 401k to settle their debts. 

    Initial Balance $80,000
    Monthly Contribution before loan $0 ************** (consumers generally discontinue contributions when they have suffered a loss of income that causes them to fall behind on their finances) 
    Monthly Contribution during loan $300 
    Employer Match before loan $0 
    Employer Match during loan $30 
    Expected Annual Return 6%
    Loan Amount $20,000 
    Interest Rate 5% 
    Loan Duration 36 months 
    Years until retirement 30 years 

    Outcome after 30 years – 

    401K Value (no Loan) $481,806.02
    401k Value (with loan) $544,434.28 

    So, by borrowing and solving their problem, they increase their nest egg at retirement by $62,628.26.

    I used this calculator for these calculations http://www.ncpa.org/401/d401kwa1_1.php. The other one didn’t work correctly with this scenario. 

    • See the attached image. I removed the 401(k) contribution. According to the calculator the difference would be $563,266 with bankruptcy and $522,083 with the loan.

      If we remove any further contributions at all until retirement the difference becomes $482,816 with bankruptcy and $481,424 with the loan.

      As I said in the original article the area of concern was the impact of getting back to being able to save again quickly, with bankruptcy versus a loan approach.

      So If we look at the scenario again with no percentage of credit card payments invested and only a $300 + 30 monthly contribution the results are a retirement balance of $814,953 versus $748,105 with the loan.

      • I appreciate this article very much. I think the points of consideration that you make are great. But, I’m either doing something wrong or the calculator isn’t accurate. 

        When I run the numbers with the $300 + $30, the results of this 
        http://www.ncpa.org/401/d401kwa1_1.php are $813,295.98 with no loan and $810,919.77 with one. Am I doing something wrong? Please see the attached images. 

        The source of the images are from http://www.ncpa.org/401/d401kwa1_1.php.

        • The big difference here is you’ve added a $300 monthly contribution on top of the $599 monthly loan payment during the repayment period. If that is something a consumer can handle, then by all means they should. 

          But remember, my calculator assumes the consumer will continue the contributions after the loan repayment. In that case the numbers work out as $814,953 with BK and $748,105 with the $20,000 loan.

          I can’t speak about how the other calculators out on the web calculate their outcome. The reason I spent so much money to have this calculator developed was because for the bankruptcy versus 401(k) loan scenario I could not find a calculator online.

          As I said, the calculator we created here was developed by a CFP, actuary, and a statistician who is an expert in financial forecasting. I guess there could always be some error in calculation but to really compare we’d need to find another bankruptcy vs. 401(k) loan calculator and compare the results.

          • Okay, I see the difference in our figures now. That makes perfect sense. With a 3 year loan, for most consumers, it won’t be doable. Unless they haven’t discontinued their contributions. 

            If consumers go with a 5 year term on a $20,000 loan their payment would be $377.42 per month. 

            If they’re settling, they would be resolving roughly $40,000 with the $20,000 loan. 

            From my experience, consumers that are in distress are paying closer to 3% of the balance as their minimum payment. 

            But, I’ll use the figure Charles mentioned – 2.5%. 

            Approximate minimum’s on $40,000 at 2.5% are $1,000. 

            Add the $300 contribution to the loan payment = $677.42

            $1,000 – $677.42 = $322.58 monthly savings (32% reduction)

            And, of course this is with the assumption that they already discontinued contributions. 

            If they didn’t, then it would be a $622.58 monthly savings. (62% reduction)

            And, of course if they have previously discontinued the contributions, the loan can make a lot of sense and have great benefit to their retirement as I outlined in a previous comment. As it may enable them to contribute again.

            Now, the greater danger and risk to the consumer with a longer term loan, is the longer exposure to job loss. 

            The consumer would be subjected to two additional years of the possibility of the loan converting to a withdrawal and becoming taxable and penalized if they lose their job.  

            So that risk must definitely be considered. 

            If you’re a consumer reading this and you’re considering this option, talk to your 401k administrator about your companies policies regarding job separation and your loan converting to a withdrawal. 

            Some employers enforce this policy and some don’t. It is wise for you to become aware of your particular companies policies regarding this prior to committing to your loan. 

            Also, I ran the numbers on the impact to retirement savings with a 5 year term vs. the 3 year term.

            The end result is $813,295.98 with no loan and $809,835.26 with one. So, there isn’t much exposure with that and it can be offset with an approximate $500 contribution made immediately after the loan is paid.

            Anyway, good stuff Steve. Thank you for taking the time to write about this. 


          • It’s all academic but we are not comparing apples to apples. The example in which I used the 20,000 loan was to pay the debt in full and not settle it.

            Anyway, it got a conversation started and that’s a good thing.

          • It’s a great conversation to have. I wasn’t comparing. My point was to demonstrate that there are ways to coordinate 401k loans so they have very little to no impact on retirement savings. 

            And, for consumers that have discontinued their contributions, my point is the loan may enable them to enhance their retirement savings by freeing up enough monthly cash flow so they may contribute again.

            “The reality is that a 401(k) loan to pay off debt can actually cost many times over the amount of the loan when the money is needed in retirement.”

            Considering the title of the article and the quote above, I felt it would bring additional value to explain how to do it so it doesn’t cost a consumer many times over the amount of the loan. Since there are ways to do it that way. 

            Awesome conversation, Steve. Thank you for doing what you do.

  6. Also, I was kind of curious about the interest on the credit cards so I just checked that with 

    According to this calculator, it would take 83 months to pay off the credit cards at $400 a month at 16%. The consumer would spend $13,200 in interest over the period. 

    So, if the calculator I linked in the previous comment is accurate, that would mean the consumer would save approximately $13,000 after they make that additional $354.77 contribution immediately after paying off their 401k loan. 

    • The calculator is spot on with this as well. Actually it takes 80 months with a final monthly payment of $393.

      Again, in the settlement scenario we have 50% of what the credit card minimum payment being reinvested for after the settlement loan is paid off in 36 months.

  7. Hey Steve, 

    I don’t think the calculator is working correctly. When I type the calculations for the $20,000 example into http://hffo.cuna.org/12433/article/135/html the outcome is a loss of $354.77 when the loan is repaid and a loss of $2,136.63 after 30 years. 

    If their calculator is correct, that would mean the consumer would have to contribute an additional $354.77 immediately after their loan was repaid to offset all losses. 

    • In this scenario the consumer would be investing 50% of their minimum credit card payment ($200) and the $330 per month in employee contribution and employer matching.

      I compared the calculator results at the end of the loan period to the link you gave me, and they matched.

        • I’m using an apples to apples scenario with an assumption in both scenarios they would contribute half of what the minimum credit card payment would be. In the bankruptcy scenario it begins after filing but in the settlement example it begins after the loan is paid since the loan creates an additional financial obligation.

          • I see. Well, the calculations I made were based on – 

            $80,000 current 401k balance
            $20,000 loan 
            3 year term 
            $330 monthly contribution 
            5% loan interest rate 
            6% expected annual return
            $330 Monthly contributions: Loan payoffOther (including any employer match) 

            With the outcome of what I stated earlier. (please double check this to make sure I didn’t goof up)

            So, you’re saying rather than the consumer contributing the $330 monthly, they are contributing $200? 

            Or, are you saying that they’re paying the loan at $599 and the contribution at $330? Then, once the loan is repaid, an extra $200 in contributions?

            Apparently, I’m having a bad case of the Mondays… 🙂 

          • See the attached image to see the variables.

            The monthly 401(k) contribution remains at $330 for both each month. The difference is the 50% of minimum credit card payment in the 401(k) loan scenario begins after the loan is repaid so as not to pile on in those months the loan repayment occurs.

            The $599 loan payment is with the $20,000 loan. The loan payment with the $10,000 loan is $300.

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