How I used 401k loans to pay down over $80k in debt and increase income

Yes, that’s right more than $80k in debt paid down utilizing 401k loans. Now the first thing that might come into your mind is ‘what is a 401k loan’ and why would I want to use it versus just pulling money out of my 401k under COVID emergency rules or in normal times just pulling it out directly.

What is a 401k loan

A 401k loan is pretty much what it sounds like. You borrow money from your accumulated 401k savings and then pay yourself back with interest on a standard payment schedule. The IRS states as follows concerning 401k loan rules:

Loans from 401(k) plans. Some 401(k) plans permit participants to borrow from the plan.  The plan document must specify if loans are permitted. A loan from your employer’s 401(k) plan is not taxable if it meets the criteria below.

Generally, if permitted by your plan, you may borrow up to 50% of your vested account balance up to a maximum of $50,000. The loan must be repaid within 5 years, unless the loan is used to buy your main home. The loan repayments must be made in substantially level payments, at least quarterly, over the life of the loan.

You must reduce the $50,000 amount, above, if you already had an outstanding loan from the plan (or any other plan of your employer or related employer) during the 1-year period ending the day before the loan. The amount of the reduction is your highest outstanding loan balance during that period minus the outstanding balance on the date of the new loan.

(https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules)

A 401k loan is not taxable nor subject to the penalties that would apply to an early distribution from a 401k, i.e., one taken before the age of 59 ½. And there are special circumstances for anyone to consider taking a 401k loan for a house (https://www.investopedia.com/ask/answers/081815/can-i-take-my-401k-buy-house.asp). Also, a 401k loan is different from a hardship distribution (https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-hardship-distributions).

Why take a 401k loan and will my employer know if I take a 401k loan

Generally, a 401k loan provides an individual an opportunity to avoid the borrowing costs associated with traditional forms of debt. You could balance transfer from a credit card using zero or low-interest teaser rate but assuming the point of the borrowing is to pay down debt then acquiring more debt from another credit card simply makes the ‘debt hole’ bigger. Plus, at the end of the teaser rate period, generally 12 to 18 months, exorbitant interest rates kick in potentially on the order of 18% or higher.

You could also utilize a loan from a Finance facility, say GE Finance, if they still exist, I used one many years ago. The loan was for 5 years and had a stated interest rate of less than 10%, so not bad. You could also utilize a peer-to-peer lending platform like Prosper or Lending Tree, which I’ve also done in the past and will speak more about later. The loan periods are generally 3 – 5 years with interest rates varying based on credit history. In the latter case, your money would be apportioned and paid to other individual investors in your loans. I know because I am also a Prosper Investor. So those are definitely viable options. However, for me the number one and two reasons for utilizing 401k loans are, the periodic realization of capital gains inside the 401k and the interest rate that you pay on the loan is to the loan recipient, i.e., you.

I’ll expound on the first reason. For the past 10 years, we’ve experienced particularly good stock market returns of greater than 13.5% thru August 2020 (https://www.businessinsider.com/personal-finance/average-stock-market-return?op=1). However, until stock, stock funds, or plan holdings (will refer to as stock from here on out) are actually sold, any profit is paper profit or unrealized gain versus an actual profit or realized gain. For instance, if your stock holdings were $100k at the beginning of the year and are now $120k, the $20k profit is a paper profit. The only time that profit becomes real (realized) is when the stock is sold and turned into cash that remains in the fund, is invested in other instruments in the fund, or is sold and distributed from the fund. So, in essence, a 401k loan presents an opportunity to take money off the top of appreciated stock in a 401k. That money can then be used to pay down high-interest debt outside of the plan and then paid back into the plan on a periodic basis, effectively dollar-cost averaging your way back into the market. We’ve seen time and time again throughout the 2000s dramatic decreases in stock returns that have negatively impacted 401k participants (think the dot com bust, the financial crisis, and most recently the COVID-19 pandemic market loss). The COVID-19 pandemic stock market loss has since been recovered but what if January – April 2020 was your time period to retire or be forced to take a distribution from the fund, you would have done so with some of the gains up thru January – April 2020 wiped away.

Reason two for me is purely selfish, why pay a credit card company, a bank, or a finance company interest for a loan, when the interest rates are generally high versus paying interest back to yourself.

As far as the question about will my employer know if I take a 401k loan. I could not locate any definitive answer to this question except to say that companies report out a yearly status of the Pension or retirement fund they sponsor which contains information about rates of return and levels of funding. So, given that reporting, it is likely in the aggregate an employer knows how much money in the form of loans have been distributed out of the fund but perhaps not necessarily to what individual.

What are the cons against utilizing a 401k loan

There are some good reasons not to tap your 401k for loans or permanent distributions prior to the eligibility age of 59 ½.

The biggest cons to using 401k loans are:

• One’s 401k savings are removed from the retirement fund and thereby do not earn any interest, dividend, or compounding growth from the stock market thereby reduces your earning potential towards your retirement
• There is a risk that one’s job situation could change, i.e., get laid off or fired, at which point the 401k loan must be paid back immediately or the loan will be treated as an early distribution subject to taxes and penalties for distributions prior to age 59 ½
• if the distribution is not a loan, for COVID hardship or a general hardship distribution then the money is taxed and you pay a penalty
• There is a risk that the company’s 401k plan ceases
• There is a risk that the circumstances that led to debt needing to be paid off in such a fashion, i.e., in my case poor spending habits, could continue and there is little benefit gained from utilizing future retirement savings for paying off current debt

That said, assuming you’ve weighed the pros and cons and are still considering, here’s basically what I did.

My 401k Loan Experience

Five years ago, I had so much debt that the amount of money I was paying out in minimum credit card balances was barely reducing the minimum amount I owed each month. That is the interest burden on my outstanding debt was so high that my payments did not drive down the principal (the amount I actually owed before interest) and thus my required payments were actually growing each month. So, for instance, I was paying $2100 towards credit card and other debt that required minimum payments of $2050, by the next month because of interest and the minimal principal paydown I actually would have a required minimum payment of $2055. And thus, had not reduced my debt burden. Assuming the same rate of increase in minimum required payments, in 11 months I would have had a minimum required payment of $2105 while only having funds available to pay $2100. I was headed towards a real and assured debt spiral.

I stumbled upon the loan section on my employer’s 401k site really by accident. I saw the loan menu option, selected it, and then used the 401k loan calculator that allowed me to play around with amounts borrowed at the company’s then prevailing interest rate and to determine what the monthly payment would be. It quickly became apparent that if I took out an ~$20k loan I would have payments back to the 401k plan of around $375 dollars or so. Based on the way my credit card payments were spread out, across four different cards, I could eliminate one credit card bill altogether and pay down a portion of another. All told I could eliminate or rather exchange $575 or so of credit card payments for the $375 that would be required to pay back the 401k loan. Thereby, increasing my available discretionary income by around $200. And so, I did. I kind of watched and waited for about six months and decided if it worked once, why not take out another $20k loan, my plan allows no more than two at a time for no greater than ~$45k. And so, I did and applied that ~$20k to balances I had on the remaining credit cards. So, with ~$40k in loans, I was able to get the 401k loan payments to around $750 per month. The $750 was a reduction from ~$1150 I was paying to the various credit card companies; a net $400 dollar increase in discretionary income.

Great news right, yes, but my only problem was that I had not really gotten my spending under control and still had unanticipated expenses that led me to put more debt on the remaining three credit cards. The one thing I did do was put one of the credit cards away so I couldn’t spend on it.

Fast forward to late 2017 and I had paid more than half of the $40k back to myself. I had begun putting more money in an external savings account due to the increase in discretionary income. But I also saw an opportunity to get rid of more debt. With my loan balance down to about $20k, I realized my monthly payment for the 401k loan was the same as when the balance was $40k, i.e., $750 per month or so. What if I paid off the $20k and then took out a new loan for $45k. This would effectively reduce my monthly credit card expense from $1700 per month down to around $1250 per month. The loan payments were higher the second time around because interest rates were higher in 2018. On the other hand that’s an additional $450 added to my discretionary income and thus more to apply to savings outside the 401k.

Fast forward to now, the 401k loan balance is around $24k. I have approximately $21k remaining in credit card debt and will pursue another 401k loan to retire the debt. The resulting payment will be around $800 per month with no external debt payments beyond the 401k loan. So, from 2015 to now, debt payments of $2100 per month will have been reduced to $800 per month for a net discretionary income increase of ~$1300 / mo.

One side note on how I paid off the $20k when I ‘refinanced’ in 2018 and how will I pay off the $24k this time around. That’s where peer to peer lending sites like Prosper come into play. I did and will take out a loan for the $20k and now $24k. I used the Prosper funds to pay the 401k loan in 2018, waited a month or so, and took out the new 401k loan for $45k in 2018. I used part of those funds to pay back the Prosper investors and used the remaining to pay off the then outstanding credit card balances. In that scenario, Prosper investors earn a small interest rate, the credit card debt is paid down and I eventually pay myself back at a reasonable interest rate.

All told I will have retired over $80k in debt utilizing this approach, I had an income increase resulting in extra discretionary income of ~$1300 / month a portion of which was used to purchase a new vehicle, upgrading from a 2003 automobile to a hybrid-electric 2018 vehicle, and a large portion of the remaining funds have gone into increasing my 401k savings contribution and establishing a higher saving rate for my emergency fund outside of the 401k.