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I have a student loan that has 6.5% interest (highest rate of many) and would be able to repay it if I took a loan on my 401k. I know the basic trade-off is that my money may do better in the 401k than 6.5%, but what other considerations should I make?

Chris W. Rea
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Nick T
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3 Answers3

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Here are some other things to consider:

  • You must pay the 401K loan back over a maximum of 5 years. Student loans are usually longer than this, so make sure your cash-flow can actually support the new payment timeline.
  • The repayment of a 401K loan gets deducted directly from your paycheck, which may decrease the take-home pay you're expecting. Not a deal-breaker, just something to be aware of.
  • Many 401K plans won't let you make any further 401K contributions until you've repaid the loan. You'll miss out on some valuable tax-free investing because of that, which may include your employers match. There is a large opportunity cost to borrowing this money.
  • Your long-term returns in your 401K may be lowered because you'll be breaking the dollar cost average of your contributions.
  • You still have to pay interest back to your 401K account on the money borrowed. This is usually prime + one or two percent. With prime currently at 3.25%, do the math and make sure it makes sense in terms of the interest rates.
The Matt
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  • Is the "interest" on a 401k loan lost to the fund or does it become part of the IRA--that is, am I paying the interest to myself? – Nick T Apr 04 '11 at 02:57
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    You're actually paying the interest to yourself, so it becomes part of the 401K account. It's basically meant to discourage people from taking an interest-free loan from their account. The downside is that you'll be paying that interest back with after-tax dollars and that interest paid will then be taxed again once you withdraw it from the account during retirement. – The Matt Apr 04 '11 at 04:17
  • Matt The tax situation only comes into play for the fact that the student loan may be a tax deduction, but the 401 loan wouldn't be. Other that that, there's no double tax. The loan itself comes tax free, and goes back pretax. – JTP - Apologise to Monica Apr 04 '11 at 19:53
  • You're right about the loan itself not being taxed, but the interest is double-taxed. – The Matt Apr 05 '11 at 00:54
  • @Joe or @The Matt - Great point, I hadn't considered the double-tax on interest. Do you have any references on this treatment? – bstpierre Apr 05 '11 at 01:33
  • Sure, this post has some "back of the envelope" calculations: http://www.investopedia.com/articles/retirement/05/RetirementLoan.asp – The Matt Apr 05 '11 at 03:27
  • Matt - I'm still trying to uncover the fallacy of this reasoning. Maybe there is none. The circle of "lost return in 401" vs "low interest loan" appears to be the larger issue. The double taxation impact is less than a percent, correct? The marginal rate on the 3% when it's withdrawn. – JTP - Apologise to Monica Apr 05 '11 at 07:32
  • No, you're absolutely correct. Those are the two main considerations. I'm not going to argue that the double-tax would be any significant amount, in fact it's likely to be fairly insignificant as you point out. The fact that somebody has to pay interest on the loan may be something to consider, but the fact that they're using after-tax dollars to do so is probably inconsequential. – The Matt Apr 06 '11 at 01:28
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    @TheMatt: There is no "double tax" (or from another point of view you might say that whenever you borrow there is ALWAYS "double tax"). Consider an equivalent situation: Instead of borrowing from your 401k, you borrow $x from an external institution at y% interest, and you at the same time invest $x of the 401k in an investment with a guaranteed return of y%. The taxes and all the amounts are the same in both situations. But would you say that this situation has "double tax"? The taxation on a 401k loan is the same taxation you have on any loan. – user102008 Apr 12 '14 at 09:49
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If you leave your job (or lose it) the loan is due on separation. You'll pay tax and a10% penalty.

JTP - Apologise to Monica
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Don't do it! The penalty and repayment requirements of the 401K will likely be more of a headache than the student loan payments. Just pay off the student loans the normal way, or in larger chunks, if you can. Student loans often have lower interest rates than other loans.

Think of your 401k as your long term savings. Don't rob your long-term self to pay the student loans.

Jennifer S
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