Dealing with credit card debt is one of the most difficult financial problems that many consumers have to handle. One option that some people consider is borrowing money from a retirement plan to pay off the balances on these cards. While this can eliminate the balances, it could also lead to big financial problems in the future.
Function
The purpose of this method is to pay off your credit cards as quickly as possible. Most 401(k)s allow you to borrow money from them through a 401(k) loan. If you have an IRA, you would not be able to borrow money from it directly. You take the money that you get from the loan and use it to pay off your balances. Then you would have to start making loan payments to retire the 401(k) loan.
Interest Rates
One thing to consider when making this decision is the interest rates that you will be dealing with. With credit card balances, you often have an interest rate that is very high. For example, you may be paying 20 percent interest on some of your credit cards. With a 401(k) loan, you would potentially only have to pay 7 percent or 8 percent interest. From a simple numbers perspective, you would save more money on interest by going with a 401(k) loan.
Replacement
Even though it may make sense to retire the credit card debt, it will not be easy to replace the money in your retirement account. The money that is in your retirement account is money that has not had any taxes taken out of it. When you try to replace the money, you will be doing so with after-tax dollars through loan payments. This can make it very difficult to get back to the point where you were to begin with.
Changing Lifestyle
One of the issues with taking out a loan on your retirement to pay off credit cards is that it may only temporarily fix the problem. If you have large credit card debt, it is generally because you have been living above your means. If you do not fix the behavior that got you in this situation to begin with, it will not do you any good. You may run up large credit card balances again and then have a 401(k) loan to deal with as well.
Considerations
The ultimate decision should come down to how much money you could save over the long term and your current budget. If you cannot afford to make your credit card payments, but you could afford a 401(k) loan payment, it may make sense to go ahead and borrow the money. Another option to consider is a debt management plan or a consolidation loan so that you can keep your retirement dollars intact.
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