Does borrowing from 401k affect credit score

Many 401(k) plans allow users to borrow against their retirement savings. It’s a relatively low-interest loan option that some people use to consolidate credit card debt — meaning, taking a more favorable loan to pay off several high-interest credit card balances. But NerdWallet cautions against taking a 401(k) loan except as a last resort.

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What is a 401(k) loan?

Employer rules may vary, but 401(k) plans typically allow users to borrow up to half their retirement account balance for a maximum of five years. The limit is $50,000. About 1 in 5 plan holders have a 401(k) loan, according to Fidelity Investments, a large retirement plan administrator.

Consider these pros and cons:

Pros

• The loans are cheaper than credit cards; interest typically equals the prime rate plus one percentage point

• You pay interest to your own account

• There’s no impact to your credit score

Cons

• It derails your retirement savings, sometimes significantly

• Risks include tax consequences and penalties

• Credit card debt is more easily discharged in bankruptcy

• The loan itself doesn’t address the reasons you might have accumulated debt

“I cringe at the thought of using your 401(k) to consolidate your loans. So much could go wrong with this strategy,” says Brett Anderson, president of St. Croix Advisors in Hudson, Wisconsin.

Readers also ask

How do I reduce my credit card debt?

Bankruptcy and debt settlement can reduce or eliminate credit card debt, but they severely impact your credit. Debt management reduces interest rates, and its effect on your credit is less severe. Debt consolidation can reduce interest rates as well. More

Is it a good idea to consolidate your debt?

Consolidate your debt if you can get a loan at better terms and/or it will assist you in making payments on time. Just make sure this consolidation is part of a larger plan to get out of debt and you don’t run up new balances on the cards you’ve consolidated. More

How can I pay off my credit card debt?

Break the process of paying off credit cards into steps to find your best path: 1. Get a handle on what you owe. 2. See how much extra you can pay over minimums. 3. See how payment order affects your payoff date. 4. Track your progress — and plan for life after debt. More

However, when other options are exhausted, a 401(k) loan might be an acceptable choice for paying off toxic high-interest debt, when paired with a disciplined financial plan. “When employment is stable and a forward-looking budget stands to be reasonable because the major expense that created the debt has ended, then a one-time loan could make sense,” says Joel Cundick, a certified financial planner at Savant Capital Management, in McLean, Virginia.

The true cost of a 401(k) loan

Any money you borrow from your retirement fund misses both market gains and the magic of compound interest.

“Just imagine taking out a five-year 401(k) loan during this current bull market at 30 or 35 years old — it could severely impact your future nest egg,” says Malik Lee, a certified financial planner at Henssler Financial in Kennesaw, Georgia.

According to Vanguard’s 401(k) loan calculator, borrowing $10,000 from a 401(k) plan over five years means forgoing a $1,989 investment return and ending the five years with a balance that's $666 lower. (This assumes that you pay 5% interest for the loan and the investments in the plan would have earned 7%.)

But the cost to your retirement account doesn’t end there. If you have 30 years until retirement, that missing $666 could have grown to $5,407, according to NerdWallet’s compound interest calculator (assuming that same 7% return, compounding monthly).

Moreover, many people reduce their 401(k) contributions while making payments on a loan from the plan. In fact, some plans prohibit contributions when a loan is outstanding. This further damages retirement plans.

401(k) loans are tied to your company

If you leave your job, you’re still required to pay the balance of any 401(k) loans.

“If you don't repay, and you sever ties with your existing company for whatever reason, the IRS will deem the loan a distribution, and you will be taxed in that tax year,” says Allan Katz, certified financial planner at Comprehensive Wealth Management Group in Staten Island, New York. And if you’re younger than 59½, you’ll incur a 10% early withdrawal penalty.

You could be left in a deeper financial hole than the one caused by your credit card debt.

About 86% of people who leave their job with an outstanding 401(k) loan default on it, according to the National Bureau of Economic Research, compared with 10% of all 401(k) loan borrowers.

Consider other options first

An effective debt consolidation plan should allow you to pay off your credit cards within five years.

If you can’t pay off the consolidated debt within five years, or if your total debt equals more than half your income, you might have too much debt to consolidate. Your best option is to consult an attorney or credit counselor about debt relief options, including debt management or bankruptcy.

Chapter 13 bankruptcy and debt management plans require five years of payments at most. After that, your remaining consumer debt is wiped out. Chapter 7 bankruptcy discharges consumer debt immediately.

Unlike consumer debt, a 401(k) loan isn’t forgiven in bankruptcy. If you can’t repay, the loan is considered a withdrawal, and you’ll owe the IRS income taxes and a penalty on the money you’ve already spent trying to pay down credit cards.

Better consolidation options for smaller debt loads include a:

• 0% balance transfer card: If you have good or excellent credit, look into a balance transfer credit card with an introductory no-interest period. These typically range from six months to two years. This is usually the cheapest option for those who qualify.

• Personal loan: Interest rates on debt consolidation loans are lower for most borrowers than rates on regular credit cards. Your rate depends on your credit history and income.

Minimizing retirement risk from a 401(k) loan

As a rule, money in your 401(k) should stay protected for your retirement years.

“The circumstances would have to be extraordinarily special for this to be the best option to accomplish this particular financial goal,” says B. Brandon Mackie, an associate at Hennsler Financial.

If you’ve weighed the risks and decided to use a 401(k) loan to consolidate credit card debt, keep these points in mind:

• Take a 401(k) loan only if you know how you got into debt in the first place and aren't likely to be in the same position again

• Stop using credit cards as you pay off debt

• Continue contributions while you repay the loan — at least, enough to capture any company match offered by your employer — if your plan allows it

• Limit the loan to an amount you can confidently repay in a short period of time, such as 12 months or less, Mackie says

Borrowing from a 401(k) plan to pay down high-rate debt “is only as good as not getting into debt again,” says Scot Stark, a certified financial planner in Freeland, Maryland. “As a last resort, this might be OK.”

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