Posts Tagged ‘using 401(k) to consolidate pay day debt’

Advantages And Disadvantages Of Using Your 401(K) To Consolidate Pay Day Debt

The simplest ways to consolidate pay day debt on your own is by borrowing a low rate conventional loan in a way that the money borrowed should be big enough to pay off all your existing debts on various payday loan accounts. But, some people, especially the ones with bad credit, usually find it very difficult to obtain a good conventional loan. Those people often consider using their 401(k) for debt consolidation. In fact, even people with good credit score who can easily qualify for a conventional loan prefer to use 401(k) probably because they do not want to borrow loans anymore. If you are also considering this as an option, following is a brief rundown on its advantages and disadvantages that you must be well aware of.

The Legal Provisions Regarding Borrowing Money From Your 401(K)

Tapping your 401(k) account sounds to be a great idea to consolidate pay day debt, but this option has its fare share of drawbacks as well. Besides that, there are some basic legal provisions on how much you can borrow and how you have to repay the same. As per the laws applicable in the United States of America, you are allowed to borrow up to $50000 or 50% (whichever is less) of the balance available in your 401(k) account. For example, if the current balance in your 401(k) account is $20000, you cannot borrow more than $10000. But, even if you have $200000 in your 401(k) account, you can borrow only $50000.

Whether you are borrowing money from your 401(k) to consolidate pay day debt or for any other purpose, you have five years of time to repay the same provided you stay employed with the same employer. If you lose your job, you will be in a serious trouble. Besides that, a certain rate of interest (which is usually very low) is also charged on it.

Advantages

There are plenty of advantages of using your 401(k) for payday debt consolidation. For example, the amount of interest that you pay is deposited into your 401(k) account only. It means the interest charged on a 401(k) loan is not financially damaging, but yes, it is a financial burden, which you must fulfill thoroughly.

Another great thing about using your 401(k) to consolidate pay day debt is that the process of borrowing money from it is very easy and super fast. In general, all you have to do is to fill out a very simple application form. Alternatively, you can even request for the withdrawal just through a phone call.

You will also be glad to know that the interest rate charged on a 401(k) loan is very low as compared to unsecured conventional loans. The exact rate however depends on the individual plan. In general, the rate is determined a couple of percentage points higher than the prime rate. Only secured conventional loans, such as home equity loans, can offer you a better rate than this.

Last, but not the least, you can borrow from your 401(k) to consolidate pay day debt regardless of how bad your credit score is or how much you earn every month. The money deposited in your 401(k) is yours and so your request for withdrawal is always approved even if you are going through a very poor financial situation and do not have an impressive credit history.

Disadvantages And Risk Factors

The biggest disadvantage of borrowing money from your 401(k) to consolidate pay day debt or for any other purpose is that the amount you withdraw does not earn you interest anymore. For example, if you are borrowing $25000 and pay back the same in five years without making any contributions during this period, you may have to suffer a huge loss of several thousand dollars that you would have earned provided you had not borrowed it. It is very important for you to keep in mind that the money deposited in a 401(k) account does not sit idle. This deposited money is always at work and making money for you through tax-deferred compounding interest. Since the borrowed money is absent from your account for a period of 5 years, it can result in a loss of over $100000 at the time of the retirement age. Thus, there are definitely some huge long-term losses.

Besides that, when you borrow money from your 401(k) to consolidate pay day debt, you also miss out on the tax-deferred benefit of this account. In general, you do not have to pay any tax on the money withdrawn from this account after retirement, but if you withdraw it before retirement and then pay it back, it will negate that benefit. What is more, the interest you repay is also not tax deductible. Your 401(k) loan is treated as any other consumer loan and so you must pay taxes on it.

Last, but probably the most important, you can be in a very serious trouble if you lose your job within the 5 year repayment period allowed on this type of loan. Depending upon your specific plan, you will be asked to repay the full balance along with interest within two to three months from the date you lose your job. You will also be charged a 10% penalty on the balance.

Overall, as we can see, considering the potential investment losses and the costly tax consequences, it is often not advisable to borrow from your 401(k) to consolidate pay day debt. It should be your last option, which you can consider when there are no better alternatives available to you.


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