Should You Use a 401(k) Loan to Pay Off Student Loans?

Depending on your career path, getting the job you want may require a college education. But it’s no secret that tuition is expensive.

Fortunately, a student loan can provide the needed funds to complete your degree. But while these loans are helpful, there’s also the burden of repaying a loan over 10 to 20 years.

So it probably comes as no surprise that some people consider dipping into their 401(k) to pay off their loans.

Borrowing from a 401(k) can quickly eliminate student debt, but this isn’t generally advised by financial experts.

Even so, you may cringe at the idea of these seemingly endless payments.

If so, here’s what you need to know about borrowing from your 401(k) to pay off student loans.

How Do 401(k) Loans Work?

When you think of borrowing money, you likely imagine filling out a loan application, waiting for a credit approval, and then receiving your funds.

It’s different when you borrow from a 401(k).

A 401(k) loan doesn’t come from a bank, but rather from your own retirement funds.

For this reason, the process is much quicker than getting a traditional loan.

Applying for one

In fact, many employers make the process super easy.

To start the process, you’ll need to speak with your human resources manager, if this department handles the company’s benefits.

Or speak with your company’s 401(k) plan provider.

Because there’s little paperwork with this type of loan, you only need to complete a simple form.

You’ll provide your name, Social Security number, address, birthdate, and the amount you want to borrow from your account. You’ll also need to select a repayment term.

Since you are borrowing from yourself, your credit score doesn't really matter for this type of loan.

Read the form carefully because it’ll provide other details and features of the loan. For example:

  • A 401(k) loan has a minimum and maximum borrowing amount. Minimums vary by employer. So you may only be allowed to borrow from the account if you’re pulling out at least $500 or $1,000. The maximum you can borrow is the lesser of 50 percent of the vested account or $50,000.
  • This is a loan and you’re required to pay back what you borrow plus interest. Since you’re borrowing from yourself, all interest goes back into your account. The interest rate on a 401(k) loan is usually the prime rate plus one or two percentage points.
  • A 401(k) loan must be repaid within five years. You’ll repay the loan through payroll deductions each pay period, which you’ve authorized on the loan form.

How They Affect You Negatively

If you’re itching to get rid of your student loan debt and you have plenty of money in your 401(k), you may see no harm in borrowing from this account.

Maybe you’re still young and feel there’s plenty of time to recoup the money.

Because you’re paying back the account, you could also argue that a loan is far better than a 401(k) withdrawal. This is when you take money from your account without repaying it.

But while the above points are true, a 401(k) loan can have negative ramifications.

1. You’ll miss out on market gains

Borrowing from your 401(k) will decrease the amount of money in your retirement account.

Even if you borrow funds for a good purpose, less money in your account means you’ll miss out on market gains and compounded earnings—which you would have received if you left the funds in the account.

For example, if you have $30,000 in a 401(k) and you borrow $10,000, you’ll only earn gains on the $20,000 until you repay the loan.

Slower gains can also occur if you temporarily lower your 401(k) contributions while paying back your loan.

Putting less money in your retirement account also reduces how much your employer contributes, if the company you work for offers a match program.

2. You’ll pay penalties if you don’t pay back the loan

Even if you have every intention of paying back a 401(k) loan, you can’t predict the future.

And unfortunately, if you lose your job or quit before paying back the entire loan, you’re required to pay any remaining balance within 60 days.

Or else the 401(k) loan is considered a withdrawal.

A 401(k) withdrawal is subject to federal and state income tax, plus a 10 percent early withdrawal penalty if you’re under the age of 59 1/2.

Let’s say you’re in the 25 percent tax bracket and you borrow $10,000 from your 401(k).

If you only pay back $3,000 before leaving your job, you’ll have to fork over about $1,750 in federal income tax and pay a $700 penalty if you’re unable to pay back the remaining $7,000.

3. You’ll pay taxes twice

When you borrow from your 401(k), loan payments are made with after-tax dollars.

In other words, the money you put back into your account has been taxed.

This results in double taxation because you’ll also pay taxes on this money once you’re eligible to withdraw from your account in retirement.

4. You’ll lose access to financial hardship programs

When you use a 401(k) loan to pay off student loan debt, you also give up access to financial hardship programs.

These are typically available with federal student loans.

These programs help graduates who cannot afford their monthly student loans payments.

They’ll either receive a lower payment, or they’re allowed to stop making their loan payments temporarily without penalty.

If you get a 401(k) loan and can’t repay this loan, there are no hardship provisions available to help you.

The upside is that defaulting on a 401(k) loan doesn’t damage your credit score. Even so, failure to repay any remaining loan balance is considered a withdrawal. You’re then subject to taxes and penalties.

When Does It Make Sense to Borrow From Your 401(k)?

Despite the reasons “not” to borrow from your 401(k) to pay off student debt, there are certain situations when you might consider this option.

1. The interest rate on a 401(k) loan is lower

Interest rates on federal student loans are generally low, and may also be lower than the interest rate on a 401(k) loan.

But if you have a private student loan from a bank, you may be paying a higher interest rate.

If your student loan payments are too expensive and pose a financial burden, using your 401(k) to pay off this loan makes sense if the interest rate on your 401(k) loan is much lower.

Your 401(k) loan payments may also be lower than your current student loan payment, providing a little breathing room in your budget.

2. You have bad credit and cannot qualify for refinancing

Student loan consolidation or refinancing can help you get a lower interest rate and a lower monthly payment.

But qualifying for refinancing will likely require a credit check, and you may not qualify with a low credit score.

If you can’t qualify but desperately need a lower payment, using a 401(k) loan to off your student debt might be the solution.

Chances are, you’ll get a lower rate on your 401(k) loan.

And because a 401(k) loan doesn’t involve a credit check, you don’t have to worry about bad credit disqualifying you.

Alternatives to a 401(k) Loan

Allowing your retirement account to grow untouched can result in a well-funded account once you’re ready to retire.

So if possible, avoid tapping your 401(k) unless absolutely necessary, or only as a last resort.

If you leave your account alone, you might ask: What are my other options for getting rid of high student loan payments?

There are plenty of alternatives for more manageable payments.

Deferment and forbearance

As previously mentioned, federal student loans have hardship programs.

Therefore, contact your student loan provider to see if you’re eligible for a deferment or forbearance.

Both options will temporarily suspend your student loan payments, or lower your monthly payments in the event of financial hardship.

Your student loan lender can provide information on eligibility.

Compare Deferment vs. Forbearance

Deferment Forbearance
Pros:
  • You can postpone student loan repayment for an extended period of time, usually up to three years
  • You may not be responsible for paying accrued interest during deferment
  • You’re able to keep your loan in good standing and avoid defaulting on them
  • Available for many federal student loans (a.k.a. government-funded loans)
  • Pros:
  • You can postpone repayment for a few months (usually 6 to 12 months)
  • There’s no limit to the number of forbearances you can request (although you may not always get approved each time you request one)
  • Federal student loans and private student loans are eligible
  • Cons:
  • Some private student loans (a.k.a. bank-funded loans) may be eligible for deferment while you're still in school, but deferment isn’t generally an option until after graduation
  • Qualifying for deferment typically depends on the type of federal student loan you have, so certain loans may not be eligible
  • The total amount you repay over the life of your loan may be higher if you don't pay interest while you're in deferment
  • Deferment is not a permanent option - you are still required to pay back your student loans, although you've received this temporary break
  • Cons:
  • You’re responsible for paying interest that accrues during forbearance
  • Your loan servicer may set a limit on the maximum period of time you can receive a general forbearance
  • Forbearance is not a permanent option for your student loans - you are still required to pay them back, although you've received this temporary break
  • Personal loans

    Another option is to get a personal loan to pay off your student loan debt.

    This might be an option if your credit score is high enough to qualify for a loan, and you feel you can get a cheaper interest rate on a personal loan.

    This can help lower your monthly payments without touching your retirement account.

    Keep in mind, getting a personal loan to pay off a federal student loan means you’ll lose access to hardship provisions if you experience economic difficulties in the future.

    Conclusion

    When retirement is years away, you might think a 401(k) loan is no big deal since you’ll repay funds.

    But dipping into your retirement account—even if only temporary—could cause you to miss out on market gains and reduce the strength of your nest egg.

    So think twice before using these loans to pay off student debt. Consider other alternatives first.

    And if you must touch your account, pay back what you borrow as soon as possible.

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