I recently saw someone in a forum ask about paying off debt.  She was coming into some money and had multiple forms of debt including a car loan, a student loan, and a loan against her 401k.  She also owed some money to her mom.  She wondered what to pay first.

I was surprised to see some people give the advice that the she should pay off her 401k loan first. Some didn’t give any reasoning, but a few said that she would miss out on the gains of compounding returns. I will get back to that point in a moment.

There was a comment saying that she should pay back the 401k loan first because she would have to pay back the money if she lost her job, or something to that effect.

That isn’t really true though.  First, you may be able to negotiate and allow your regular payments to continue if you lose your job.  Second, if the company did want you to pay it back all at once, you can simply default.

So what are the consequences of “defaulting” on a 401k loan?  It is essentially the same as taking a withdrawal.  If you have a balance of $10,000 and you default on it (or take a withdrawal), then you just aren’t paying it back to yourself in your account.  You would owe taxes on that money, plus a 10% penalty if you are below the age of 59 and a half.

Put that way, it isn’t really all that bad.  If you lose your job, then your income may be lower for that year that you are essentially taking a distribution.  This would likely mean a lower marginal tax bracket.

I’m not saying it’s the ideal situation, but it usually isn’t when anyone loses their job involuntarily.  You might actually be in a worse situation if you had other debt and you lost your job.  I would rather have to pay taxes and penalty on $10,000 than having to keep making payments on a $10,000 loan if I lost my job.

My advice to the woman was to pay back her mom first.  This obviously has nothing to do with a mathematical calculation.  It isn’t even really financial advice, or at least not directly.  It is relationship advice.  If she owes her mother money, she should pay her when she has the money. She has a place to live and is putting food on the table.  She should pay back her mother first before paying back the banks and her own 401k account.

Without knowing the exact interest rates, I suggested paying off the student loan debt second. This is debt that cannot typically be discharged in bankruptcy.  You also don’t have collateral for it other than the supposed wisdom gained from attending college.  Really, it is the degree that is collateral that is supposed to help you get a better job.

I suggested the car loan after that and the 401k last.

Paying Interest to Yourself

When you take a loan against your 401k plan, you typically have to pay an interest rate. There may also be maintenance fees, but they may not be that significant if the loan is of a decent size. You don’t want to pay a $25 per quarter maintenance fee on a $1,000 loan, as that would be 10% of the loan in a year.  If you pay $100 per year for a $20,000 loan, then that would be half of a percent, which is obviously a much lower percentage.

The interest rate can vary depending on your plan and current interest rates.  Right now, you might expect to pay something in the neighborhood of 6%.

This is interest that you are paying back to yourself in your 401k account.  It doesn’t mean that it is irrelevant though.  You should consider this interest rate when taking out a loan because it will affect your cash flow.  When you start paying back your loan almost right away, your paycheck (assuming your employer automatically deducts it from your net pay) will go lower.  The higher the interest rate on the loan, the higher the amount that will be taken out from your net pay.

As I mentioned near the beginning of this article, a few people objected to having a 401k loan because you will miss out on the compounding returns.  But why are they assuming this is the case?

If you are paying yourself back the interest, then this is essentially the same thing.  It’s just that your return is fixed.  If your interest rate is 6%, then you are essentially getting a return from your own payments of 6% on the borrowed money.

If I could find an investment right now that paid a guaranteed 6% return, I would probably have most of my money in it.  This might not always be true if I thought there was a significant threat of price inflation in the near future.

I think the few people with this mindset believe that you can get better returns by investing, which would impact your compounding returns.  They have the conventional mindset that you should invest in broad-based index funds that will return at least 8% annually over a long time horizon.

The problem, of course, is that there is no guarantee that you will get 8% annual returns. Past performance does not indicate future results.

If there were a way to get guaranteed returns above the interest rate you are paying on your 401k loan, then they would have a good argument.  But in the real world, this is not the case.

I don’t love the idea of taking out a loan against a 401k.  Again, you still have to make the payments unless you can somehow default on it, which would make it even less ideal.

But if you have to borrow money, then you may be better off paying the interest to your retirement account instead of paying it to a bank.

I don’t want to say that I am an advocate of taking out a 401k loan.  In many cases, people are better off not taking out any debt at all.  If you are going to borrow, it should be for a good reason and not for luxury purposes.

One final thought I have is related to a mortgage.  You can take a 401k loan to use as a down payment on a house.  Again, while I would prefer having the money saved up for a down payment, a 401k loan for this purpose can allow some people to avoid private mortgage insurance and to also get a better rate on the mortgage.  This should only be done knowing that you are quite comfortable with the mortgage payments and the 401k loan payments, along with all of the other expenses that come with home ownership.

The one other interesting idea in regards to a mortgage is to use a 401k loan to pay off a mortgage. I wonder if many people have used this strategy.

Let’s say that you have $40,000 left to pay on your mortgage.  You have a sizeable 401k plan well into six figures and you can borrow up to $40,000 from your plan.

Maybe it makes sense to take out a $40,000 loan against your 401k and wipe out the mortgage. Then you have your 401k loan payments instead of your mortgage payments.  But the interest would be going towards your retirement account instead of to the mortgage company.

I am not saying this is a good strategy for everyone.  It depends on your situation.  It depends on the maintenance fees for the 401k loan and other fine details. But it may be something for you to consider if you are in this situation.