Get Out of Debt Guy - Steve Rhode

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

1-844-335-1967

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:

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.

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

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.

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.