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A 401(k) Loan Might Not Be the Best Way to Pay Down Credit Card Debt

February 18, 2001|LIZ PULLIAM WESTON

Q: Several years ago I went to graduate school, and now along with my education I have a great deal of debt in the form of student loans and credit cards. I am paying off as much as possible on the credit cards every month (my $15,000 balance is split among three cards, and I am not using them for purchases, but it seems to be taking forever to make a significant dent).

Meanwhile, I am contributing 7% of my salary to my company's 401(k) plan. They match only 50% of the first 4%. The market seems to be fairly slow right now, and I am wondering whether I should take out a loan on my 401(k) to pay off some of my credit card debt, or whether I should decrease my contribution temporarily to have the extra cash.

I am aware of the downside of taking money out of the 401(k)--loss of earnings with compound interest, the need to pay back the loan immediately if I change jobs and the fact I'll be paying back the loan in any case with after-tax dollars--but I feel I'll never get ahead if I don't get this debt taken care of. Any advice?

A: Are you prepared not to charge another dime on a credit card until your 401(k) is repaid? Because that's the kind of commitment you should have if you're going to raid your retirement funds. Tapping your retirement money is always dangerous; it's pointless if you're just going to run up more debt.

The advantage of a 401(k) loan is that you'll be paying interest to yourself rather than to a credit card company. But there are still ways you could come out poorer.

You already know that you'd be required to pay back the loan almost immediately if you lost or quit your job. Otherwise, you'd owe taxes and penalties on the withdrawal.

You also risk reducing the amount of money you're likely to have for retirement, because that $15,000 has been taken out of the market temporarily and won't be earning returns for you. If the market does particularly well, the ultimate cost to your retirement savings could be high. The market may not be doing great right now, but you never know when that might change.

You also may wind up being in debt longer if you take out a 401(k) loan. You can always pay more than the minimum balance on a credit card, and you should if you ever expect to get out of debt. But some 401(k) programs don't let you make extra payments on loans.

Instead of a loan, you could consider reducing your 401(k) contributions, but you may find it doesn't boost your paycheck very much, thanks to the extra income taxes you'd have to pay. (Fidelity Investments has a calculator at http://www.401k.com that you can use to see the after-tax results of changing your contributions.)

You also might consider taking another hard look at your budget. An extra $100 a month, for example, probably would shave more than a year off the time it takes to pay off the debt and more than $1,000 off your interest costs.

If you can't trim any more in the obvious places--dinners out, cable television, cell phone--consider tinkering with your student loans. Switching to interest-only payments or stretching them to a 15-year or 20-year repayment schedule from a 10-year schedule could give you a little breathing room. You can pay more on your loans as soon as your credit card debt is retired.

Risk Tolerance Is Issue

Q: You recently advised a reader whose retirement portfolio was heavily invested in Internet and technology stocks, and who was complaining about being down more than 30%, to talk with his advisor about diversifying. In effect you are advising this man to sell at the bottom. The man's financial planner should indeed tell him that "everything will be fine" and to sit tight, because technology is obviously headed back up. Rest assured I won't be seeking any advice from you.

A: You don't need advice, dear man, because you have the uncanny ability to predict the future--and to know what was in this reader's portfolio. Although some technology stocks have seen impressive gains recently, others are still flopping around near their 52-week lows. You're assuming his advisor loaded him up on Microsoft rather than EToys or Pets.com.

For those of us who lack your extrasensory perception, diversification and an awareness of our limitations are essential. The original reader learned that he was exposed to far more risk than he was comfortable taking. Diversifying our portfolios may indeed require us to sell some investments that could later gain in value. The trade-off is that we reduce our exposure to loss. Those who worry excessively about selling at the bottom can redeploy their assets over several weeks, rather than doing it all at once.

You may find that a big gamble on a narrow sector pays off for you. The average individual investor probably can't stomach that much risk--especially once he or she realizes how very unpredictable the market can be.

*

Liz Pulliam Weston is a personal finance writer for The Times and a graduate of the personal financial planning certificate program at UC Irvine. Questions can be sent to her at liz.pulliam@latimes.com or mailed to her in care of Money Talk, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA, 90012. She regrets that she cannot respond personally to queries. For past Money Talk questions and answers, visit The Times' Web site at http://www.latimes.com/moneytalk.

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