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401(k) Loan

401(k) loans can be among the most misunderstood borrowing options when it comes to consolidating debt. It can feel like a win to wipe out high interest consumer debt with a loan from your 401(k). However, borrowing from your retirement account to consolidate debt is usually considered a loan of last resort. 401(k) loans could have a negative effect on your retirement plan and in the case of job loss could incur taxes and penalties if the outstanding balance is unpaid. The investment opportunity cost and potentially negative effect on your retirement can make it one of the less desirable options when it comes to debt consolidation. There can also be a tendency to acquire new debt on freshly available credit lines from the accounts that have been consolidated.

Pros

Interest portion of payments deposited to 401(k) account

Paying yourself back plus interest instead of making payments to the bank can appear advantageous.

No credit check or effect on credit scores

Borrowing from your 401(k) has the advantage of not affecting your credit score while possibly allowing you to consolidate high-interest debts.

Improved credit score

Paying off credit cards with funds from your 401(k) may reduce your credit utilization ratio (the amount you owe on credit cards vs. your available credit). Unused available credit represents responsible borrowing habits, which can increase your credit score.

Cons

One- to five-year repayment period

A shorter repayment period means higher monthly payments.

Administrative fees may apply

401(k) administrators generally charge setup and annual maintenance fees to process and support retirement account loans.

Lost value of investments and higher buyback prices

When you borrow money from your 401(k), investment shares that you have accumulated over time must be sold to generate the proceeds of the loan. New investment shares are then repurchased each pay period as you repay the loan. Because markets historically rise over time, you may not only lose out on the price growth of the shares you sold (including any applicable dividend payouts) but you could end up paying more for your investments if markets are rising while you are buying your shares back.