Should You Borrow From Your 401K to Pay Off Student Loans?
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If you’re trying to eliminate student debt, taking money from your 401(k) can seem like a good option. Instead of just permanently withdrawing the money, you can use a 401(k) loan instead. Here’s how it works.
A 401(k) loan lets you borrow money from your own retirement plan and pay it back to yourself. As with other loans, like online loans, you have to pay interest on the loan (usually equal to standard bank loan rates). However, with a 401(k) loan you pay the interest to yourself into your 401(k).
You can opt for a maximum repayment period of five years. If you repay the loan on time, you don’t pay any taxes on the amount you borrowed or the 10% penalty for withdrawing from a retirement account before age 59.5. If you don’t repay the loan, the unpaid balance is treated as a premature retirement distribution.
There are several potential benefits to taking out a 401(k) loan to pay off your student loans.
- Save money on interest. You’ll no longer have to pay interest on your student loan debt if you pay it off. The interest on the 401(k) loan isn’t really a cost since you get it back into your own 401(k).
- Improve your cash flow. With your student loan payments eliminated, you’ll have one less monthly bill to worry about. You can usually repay a 401(k) loan through payroll withholding just like your normal contributions.
- Improve your mortgage approval chances or credit score. Student loan debt increases your debt-to-income ratio that’s used for mortgage approvals. It can also increase your credit utilization and affect your credit score. 401(k) loans are payments to yourself not to a lender, so they don’t count against you on your credit report or when applying for a mortgage.
There are a few possible downsides to a 401(k) loan.
- Missing market gains. Student loan interest rates are usually much lower than the 10% annual return of the S&P 500 index. In most years, you’ll make more money by staying invested and paying the interest. In fact, regardless of your decision regarding the 401(k) loan, you should consider your investments beyond your retirement accounts and be sure you’re maximizing your gains. Online investment websites are a simple way to set up a brokerage account and take advantage of the market.
- Loss of flexibility. If you can’t pay your student loan payments, you usually have options including deferments or shifting to income-based repayments. If you can’t make a 401(k) loan payment, there are no options except to take the taxes and penalties.
So what should you do? It depends on how the advantages and disadvantages line up with why you want to pay off your student loans faster.
If you choose not to take out a 401(k) loan, there are other simple alternatives for paying off your student loans. For example, refinancing your student loan can be a simple process. Our review of the top student loan refinancing companies is a great way to get started eliminating your student loan debt.
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