Retirement Funds off Limits for Debt Repayment

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Published August 12, 2011

| CreditCards.com

Dear Opening Credits,

Hi. I am 29 years old, and have about $37,000 in debt. My debt is made up of 70% college, 18% auto and 12% credit card and misc. I have no savings. I would like to get out of as much debt as possible before I buy a house next year. I have two things in mind that I am looking at doing. First, I would like to take a loan out of my 401(k) to payoff my auto, credit card and miscellaneous debt. I think this will boost my credit score, which will give me a better interest rate on my home purchase. Second,I would like to take either a withdrawal or a loan from my 401(k) for the down payment on the house. Since I'm young, I can make that money back since I have yet to hit my prime money making years. I also have the option of borrowing my entire 401(k) and paying off all my debt and essentially start from scratch with no debt and no retirement funds. Do you think this is a financially sound plan? What would you suggest to a person my age? 

-Travis 

Dear Travis,

I get where you're going with all this, and do admire the creative flow of ideas. Except I'm not big on the plan itself. It's got some flaws, with the most egregious being tapping into your 401(k). Money in retirement plans is intended to be for those years when you don't want to or can't work. Yes, you're young(ish), but building up enough to live on later takes plenty of time.

There are also serious taxes and penalties to consider when you withdraw funds from a tax-deferred retirement fund early. And although loans against them don't have the same consequences and do have advantages (like being able to borrow up to half of your vested balance at a relatively low interest rate), I still wouldn't recommend one in your situation. While it won't be reported to the credit bureaus, mortgage lenders will require you to reveal the loan. Even if it does raise your score,it will be counted as part of your overall debt. Know too that if your job ends, you'll probably have to repay what you owe within 60 days -- or suffer those hefty early withdrawal penalties. That's all way too risky for my taste.

Instead, I recommend you develop a budget that allows you to live within your means, free up cash to pay down debt and save money for your down payment. In order of importance:

--The credit cards and the mysterious "miscellaneous" debt, totaling approximately $5,000. Chances are they have the highest interest rates, so pay the most to them. In the meantime, stop borrowing. It doesn't make any sense to get into further debt as you're paying it down. You can use them again when the balances are gone, but only if you'll pay off what you charge before the grace period ends.

--Your car loan at roughly $7,000. It probably comes with the second most expensive finance charges, so that comes next. If you pay your cards off before this loan is complete, add the extra money to these payments to accelerate payoff.

--The $25,000 or so in student loans. Assuming they're federally guaranteed, the interest rates are probably quite good. Making them even cheaper is the interest tax deduction -- up to $2,500 -- that you can claim against your income. Keep them current and bump up the payments after your more costly obligations are history.

While you're doing all this, work as hard as you can. A mortgage lender will want to see evidence of a secure job and cash in the bank. As for that credit score, it's also important of course, but as your balances decline, those numbers will rise.

Sound good, Travis? I hope so. It's a little less exotic than yours, but it will be safer and more effective in the long run.

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