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Borrowing from retirement savings to pay off debt - math people/Dave Ramsey people, help!

2K views 13 replies 9 participants last post by  LifewithSage 
#1 ·
Yep, another one of those threads. :)

I'm a daily lurker in the F&F forums (sometimes thrice-daily!) and I've gained a lot of knowledge here.

However, I need some help from you wise women to help me wrap my head around this:

Dh and I have a fairly tight budget. He works, I'm the SAHM with a token weekend job that brings in beans. We were debt-free except for mortgage/vehicles, and then we paid off our car. We owe on our truck, bought privately from his parents.

Anyway, this past year we accumulated credit card debt. :( It is more than I could pay off with our tax refund, and the card is a 10.99% APR.

I know about compounding interest, so I'm not excited about borrowing from our retirement savings plan, but the interest rate for a general loan is 2.875%. The total interest paid (if I paid it off over 5 years, which is a huge length....it would be within a year or two) is less than $300, whereas the total interest paid on my CC would be several thousand dollars over the equal loan terms.

I'm looking at Dave Ramsey's plan & he is saying to minimize your retirement contributions (we currently save 11%) until you have your CC debt paid off. If I do that, what is the difference between:

(1) Minimizing the contributions and NOT taking the loan: go down to our 4% match, which would free up $400/month to pay this bill

(2) Not minimizing the contribution & maintaining the 11% contributions BUT taking a loan at 2.875% (and not making the return on the borrowed money)

Does anyone have any insight on this? I'm wrapping my head around making us debt-free (minus house and truck) again in 2011. I know DR wants me to just pay the card down as fast as I can, but does it mathematically make sense in light of the APR versus the loan interest rate at 2.875????

Thanks for any help you can give me.

P.S. -- I ordered DR's FPU program and I'm optimistic that we're going to get out of the credit card game altogether this year, but I've got to tackle this first...
 
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#3 ·
Math people & DR people aren't the same. No, his program is not set up to be the best mathematical way to deal with debt.

To answer your "which is better" question, it's necessary to know the amount of credit card debt that you have. In general, though, I'd have to be pretty desperate to borrow against a 401(k) to pay off a credit card. I would search for any other options first and do it only if there were no other choice because I think (and this is why DR favors being debt-free over doing the math) that once you borrow against retirement once, that becomes easier unless you have an about-face in the way you handle money.
 
#4 ·
well, this is interesting. I think you need to look at how long each of these scenarios will take to get you to your goal of paying off your credit card debt. I understand that the interest you are paying on the 401k loan is not too much, but what a lot of people don't realize and don't take in account is that the repayment of the loan is not tax-free. Meaning, every payment you make will come out of your already taxed dollars, unlike your contribution. However, if you lower your contribution you will also be paying the credit card with already taxed money since going from 11% to 4% means that 7% more of your paycheck is taxed. When you figured in the $400 did you factor in the additional taxes that will be taken out of that money? It could be both federal and state if your state allows you to contribute that money tax free as well.

So, if lowering your contribution will pay it off in about the same time as taking a loan out and repaying it then I would go that route. The difference being that the money that stays in your retirement account is earning (hopefully LOL) and once you take that money out, that is less money you are earning interest on.

Really though, is there a way to adjust your budget so that this credit card can get paid off in about the same time? I know that's no fun and it's not the easiest scenario, but generally is much better than losing out on the tax advantages that you're currently receiving.
 
#5 ·
Quote:
Originally Posted by VisionaryMom View Post

Math people & DR people aren't the same. No, his program is not set up to be the best mathematical way to deal with debt.

To answer your "which is better" question, it's necessary to know the amount of credit card debt that you have. In general, though, I'd have to be pretty desperate to borrow against a 401(k) to pay off a credit card. I would search for any other options first and do it only if there were no other choice because I think (and this is why DR favors being debt-free over doing the math) that once you borrow against retirement once, that becomes easier unless you have an about-face in the way you handle money.
Oh, I know. :) I meant both types of people: DR people (since I'm becoming influenced by his materials lately) and math people .... which aren't the same. In fact, there's an interesting article titled "Dave Ramsey is bad at math" that I found when I was wondering about the snowball method since it made sense to me intuitively (I get the emotional part) but not at all mathematically (since he ignores interest rates). No, I wanted the opinion of both groups. :)

And you've nailed my hesitation about automatically taking out the 401(k) loan: I'm afraid without die-hard money commitment (which I cannot guarantee re: my dh, who believes we're quite frugal as it is....), we're just going to end up doing this every other year and not "learning the lesson", so to speak. The CC total is 11K, btw. I was embarrassed to admit that in my first post.
 
#6 ·
Quote:
Originally Posted by LifewithSage View Post

well, this is interesting. I think you need to look at how long each of these scenarios will take to get you to your goal of paying off your credit card debt. I understand that the interest you are paying on the 401k loan is not too much, but what a lot of people don't realize and don't take in account is that the repayment of the loan is not tax-free. Meaning, every payment you make will come out of your already taxed dollars, unlike your contribution. However, if you lower your contribution you will also be paying the credit card with already taxed money since going from 11% to 4% means that 7% more of your paycheck is taxed. When you figured in the $400 did you factor in the additional taxes that will be taken out of that money? It could be both federal and state if your state allows you to contribute that money tax free as well.

So, if lowering your contribution will pay it off in about the same time as taking a loan out and repaying it then I would go that route. The difference being that the money that stays in your retirement account is earning (hopefully LOL) and once you take that money out, that is less money you are earning interest on.

Really though, is there a way to adjust your budget so that this credit card can get paid off in about the same time? I know that's no fun and it's not the easiest scenario, but generally is much better than losing out on the tax advantages that you're currently receiving.
Thank you! I totally hadn't thought about the pre-tax/post-tax thing. Now, I'm super afraid that the math to figure this out (pre-tax/post-tax/rate of return on 401k vs. interest rates...) is completely beyond me. This is important, though, so I'm going to try.

I can do some budget adjustments -- i.e, we just finished paying on the car, so I'm going to divert the former car payment money to the card -- but there's only so much I can do with the amount of money dh brings home. I have a monthly spreadsheet where most of our dollars have jobs, and I think I'm going to try to hit a zero-balance budget this month...where every extra dollar goes to the card while I sort this out.

Ultimately, I want to be smart about the way I pay this off, since I'm feeling so dumb about getting into this spot to begin with. We took a vacation we couldn't afford with dh's aging/ailing parents because they asked us to and were so excited about it and we knew it would be the last big one they will likely be going on and it was a big emotional thing for them to include us on this particular trip ..... and so all of that in mind, we went anyway. Then, we racked up more debt since our budget really doesn't (didn't?) allow for CC payments.... Ugh.

However, I don't want to be so smart about it that I've sort of tricked us into finding a "Way Out", should this happen again. Which, Please God, it won't .... since I've established an EF and I'm never traveling again without doing so in cash.... I hate resenting family vacations for the money they're costing.
 
#7 ·
well, I know trying to figure out tax implications is a little more difficult LOL. However, you can sort of look at it like this. The money that is in your retirement fund right now was put there tax-free so the adjusted tax rate is 0%. The money that you'll be paying with is your tax bracket less than what you originally put in (i.e. the amount of the loan)... so the interest rate IMO of the 401k loan is the actual rate that is being charged plus your income tax rate. It's not a perfect science, but it'll give you an idea. So in my mind the tax rate on the money you're borrowing is the stated interest rate plus the tax rate since you'll be paying it back with money that costs you more. I don't know if I'm really explaining this correctly. I would ignore the rate of return on the 401k for your calculations to make it simple. Or, if you really want to, you can get a statement and look at what your account earned over the time period that you expect to pay it back in and apply that rate. It's certainly not the best representation, but probably the easiest. Or, you can google average 401k return LOL and see if that come up with anything

Most companies have policies in their 401k plans about loans and how they are repaid. A lot of times they are repaid through a mandatory payroll deduction that is based upon the length of time the loan is taken out for. So, you need to factor that in as well and look at your 401k plan or talk with your DH's HR dept. It would totally suck if one month you really needed that money and you couldn't have it due to the company's policy of repayment.

What you could do is a combination of lowering your 401k contributions and making changes to your budget. Don't go all the way down because I think the savings in taxes is important, but maybe a combination of the two will net you the same amount as either lowering it all the way to the match or the monthly repayment method.

I also want to put it out there that it's sometimes a bigger lesson and makes us think more carefully if we have to work hard to repay our debt vs. finding the easiest way out of the solution right now.
 
#8 ·
Okay, that makes sense to me, I think. :) Thanks! I'm not mathematically inclined, so figuring out rates and such was beginning to overwhelm me.

Our rate of return for the past year was 12% when I checked yesterday. However, we're still sort of making up for 2008 so it's nice to see it come back up a little.

Your last sentence is sort of what I'm thinking about now, though. I'm wondering if we should just suck it up and not do anything with retirement savings and contributions and just pay the CC back despite the 10.99% APR. It just makes my stomach hurt to think about that much time and interest, but perhaps that's the lesson here, anyway....
 
#9 ·
How did you end up with cc debt? I wouldn't take out at loan against retirement, I'd be more prone to reduce your retirement contribution to match til its gone. Can you afford to have 11 per cent going? What I'm basically asking if what is the cc debt from? Do you need to pick up another shift at work/income problem or was there some spending that can be stopped?
 
#10 ·
Be careful! I think this is one case where DR and the math agree.

My understanding is a 401k loan is a bad idea in most cases (even the math). When you pay back the loan, you'll be paying it back with post tax dollars, and you will also be paying tax on it when you withdraw it when you retire. Plus the hit of tax deffered investing while it's out of there. Finally, check your plan-- you may not be able to contribute while you have a loan out on your 401k-- meaning you'll miss out on the 4% match.

All that assumes that you don't get fired or laid off, or have to quit your job while you have a loan outstanding-- you'll owe 10% extra if that happens, and you aren't able to come up with the money ASAP.

If I were you, I'd look somewhere else in the budget for money-- reduce your 401k contributions down to the match, and figure out what else you can possible cut to get this debt paid of ASAP. I've heard that you can get your rates reduced, or use balance transfers to get your interest down, IF you are on top of it. Remember, 2 things affect the interest you pay-- the rate *and* how long it takes you to pay it off. Dave would say to use that sick feeling to motiviate you to get that balance down as fast as possible!
 
#11 ·
I think you have gotten good advice so far, and IMO the math part should not even enter into this discussion as you can't calculate the RISK you would be adding to take out the loan. Both those problems seem fairly unlikely, but how would you live if your DH had no income and you needed to fork over the balance of the loan at the same time? Two points:

1) Many times if your DH is fired or forced to quit the remainder of the loan will come due very quickly and must be paid in full (unless your company has some kind of work-around, but that seems unlikely).

2) You are forced to make a fixed monthly payment that is non-negotiable which could really end up hurting if your circumstances change. If you have a bad month or two you can send the minimums into a CC company and just eat the interest--you will not have this flexibility with a loan.
 
#12 ·
I would definitely NOT borrow against retirement savings to pay off debt like you described. There IS a lesson there and I suspect you know that.
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I'd do a combination of things, but the specifics would depend on factors not discussed thus far in this thread. I would not go from 11% contributions down to 4% contributions unless there were other indicators (NOT debt from a vacation and subsequent monetary decisions). I would, however, drop the contributions a little bit (down to 8-10%) and reduce any/all possible other expenses. AND, I would do whatever I could to raise some extra income. Sell excess items. Work a little extra. Whatever else fit the situation.

Psychologically, paying off $11K of cc debt by borrowing against a 401k is a really, really bad idea....which can absolutely lead to bad financial ideas long-term.

I am a finance person, but I firmly believe you have to take human nature into account when dealing with money. Money management is NOT just math when real people are involved.

I don't follow Dave Ramsey, but I hear about him a lot. I agree with some of his beliefs because he does seem to take certain aspects of human nature into account. I disagree with some of what I hear he says, too, but I have not taken the time to look him up myself and form my own solid opinion.

Regardless of anything else, I think you already know what you need to do. I wish you all the best!
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#13 ·
I don't buy into the whole "you'll only learn your lesson if you're paying through the nose" sentiment. :/ But I totally agree with this post:

Quote:
Originally Posted by sarafi View Post

I think you have gotten good advice so far, and IMO the math part should not even enter into this discussion as you can't calculate the RISK you would be adding to take out the loan. Both those problems seem fairly unlikely, but how would you live if your DH had no income and you needed to fork over the balance of the loan at the same time? Two points:

1) Many times if your DH is fired or forced to quit the remainder of the loan will come due very quickly and must be paid in full (unless your company has some kind of work-around, but that seems unlikely).

2) You are forced to make a fixed monthly payment that is non-negotiable which could really end up hurting if your circumstances change. If you have a bad month or two you can send the minimums into a CC company and just eat the interest--you will not have this flexibility with a loan.
These are serious issues. And I say this as someone who has taken a 401k loan (and calculated all of that risk, etc.) We opted to do it to finance something other than credit card debt during a time when taking that loan out "froze" that amount from being invested in the market--which for us was optimal because the plan didn't offer a "savings/money market" type of account with low risk during a time that the market was tanking. The interest was repayable to the 401k account--so the low interest paid was paid into our own pockets. For us, it was more than just how to pay for something and went into "how do we keep this money from tanking in the market given the options in the plan".

If it were me in your shoes, I'd probably be more likely to drop my contributions to the 4% full match and pay the debt off quickly as a happy medium. The psychology around debt is that for most people, if you stay in it for too long, it just becomes "the way it is". And that's another risk to calculate. It's a payment built into the budget. Blech. I don't regret what we did, I just think you have a less risky alternative and if not for the investing issues of our 401k, I'm not sure I would've taken that route.

I would also look into whether or not there is a hardship clause if he loses his job and you have an outstanding balance on a 401k loan. My husband's has something like that although we owned our home at the time so I suspect we couldn't possibly qualify.

Also, both plans we've been involved in have only every allowed you to pay the scheduled payment, or the balance in full. There was no "making extra payments" allowed, but check your plan to see if that's an option, too. Because then, I might consider it but it's still a bigger risk than necessary.

Another thing to consider: if you drop the contribution to 4% and get a paycheck to see the full effect/net results and don't like it--you COULD turn around and change it again back to the 11%. We've done that, too. Figuring out the tax implications is a nightmare. And I'm a math person (and a money person).
 
#14 ·
You also need to check your plan to see if there are any limitations to when you can change your contribution. The plan that we have here at work only allows us to change our contribution on the first day of every quarter and that's it, I've also worked other places where it didn't matter when you did it and you could do it as often as you liked. There are lots of different plan policies, so I feel that it is very important to understand the plan you're participating in and what it means to you in these situations.
 
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