Should I Use My 401K to Pay Off My Credit Card?

Credit card debt can be challenging to navigate since your balance can grow monthly as interest accumulates. One solution is borrowing against or withdrawing from your 401k. This could help you get out of debt faster and protect your credit score, but it can also hamper your retirement goals.

This article will cover the pros and cons of paying off credit cards with your 401k, as well as offer some alternative methods to pay off debt.

Pros and Cons of Paying Off a Credit Card with Your 401k

Here are some benefits and drawbacks of paying off credit cards with your 401k retirement plan:

Pro: Reduce Interest Expenses

Credit card and 401k loan interest rates are based on the prime rate. However, credit card APRs are much higher than 401k loan rates. They tend to be around at least 23% but can climb higher. This can make it hard to pay down debt.

On the other hand, 401k loan interest rates tend to be around 6.5% to 7.5%.

Pro: Improved Credit Score

Borrowing from your 401k doesn’t require a credit check, so you’ll avoid credit-damaging hard inquiries.

Paying down credit card debt also reduces your credit utilization, one of the five FICO credit score factors. Utilization measures your total credit balance against your total credit limits and each card’s balance against its limit.

Lowering your utilization can boost your score, allowing you to qualify for better loan opportunities in the future.

Con: Fewer Retirement Savings

Withdrawing from or borrowing against your retirement account reduces your tax-deferred savings and the effects of compounding returns.

These effects can slow your progress toward your retirement goals. Check your balance against your goals with a retirement calculator before withdrawing from or borrowing against your 401k.

Con: Penalties and Taxes

401k withdrawals can incur income taxes and penalties. This reduces the amount you have for debt payoff and retirement savings.

A 401k loan may help get around this. However, failing to repay the loan could cause it to be classified as a withdrawal and lead to taxes and penalties.

Alternatives to Paying Off Debt with Your 401k

401k loans and withdrawals may help reduce credit card debt, but neither are ideal solutions. Here are a few options that may work better:

1. Create a Budget and Reduce Expenses

A detailed monthly budget gives you a roadmap of your income and spending. Find opportunities to reduce spending to free up funds for debt payoff.

For example, cut unused subscription services to save money each month. You can also temporarily cut subscriptions you use to free up even more for debt payoff, then resubscribe later when you’re in a better financial position.

Stick to this budget as best as possible every month and create a credit card payoff category to allocate a specific monthly payoff amount.

2. Refinance and Consolidate Debt

Refinancing a credit card involves paying off the old card balance with a new loan at a lower rate.

You may also consolidate debt with one loan if you have multiple cards. This involves getting one new loan at a lower rate to pay off all the credit cards.

There are two ways to refinance and consolidate:

• Loan: This lets you consolidate and refinance all credit card debts into one predictable fixed payment at a lower rate.
• Balance transfer card: This lets you transfer several credit card balances to a new card and pay 0% interest for a certain period.

3. Negotiate Lower Interest Rates

Lenders ultimately want to make their money back. Therefore, they may offer some room to negotiate a lower interest rate.

Explain your current situation and reiterate your commitment to being a responsible borrower and paying off your debt. If your lender agrees to a lower rate, you can save money each month and pay down debts faster.

The Bottom Line

401k’s can help pay down credit card debt, but you may lose out on any savings through taxes and penalties. Plus, it slows down your progress toward retirement.

Instead, create a budget, cut expenses, refinance and consolidate if possible, and negotiate lower rates. These solutions can help you climb out of debt while preserving your hard-earned retirement savings.

Sources:

https://www.forbes.com/advisor/credit-cards/average-credit-card-interest-rate/ (Average APR data)

https://www.debt.org/retirement/401k-loan/ (Average 401k loan interest rates)