Ask the grumpies: 401(K)/403(b) loans

Dr. Koshary asks:

I was talking with my financial consultants – my father and stepmother – last week, and they floated an idea to me that had never crossed my mind before.  They suggested that, if and when, FSM willing, I land a tenure-track job and can look forward to a steadier income, I should borrow a sum of money from my 403(b) and use to pay down my student loan debt.

I immediately disliked this idea, thinking of your observation that, in the grand scheme of things, student loan debt isn’t necessarily the worst thing to carry for a while.  I have around $23,000 in fully subsidized student loans, consolidated at a fixed APR of 5%.  I’m three years into a 20-year repayment plan, so after another 17 years, the loan will be fully repaid, and I will have paid a total of about $41,000 with the yearly interest.  My monthly payment is $173.18, which hardly seems onerous compared to what could have been.  As long as I can avoid any huge unanticipated expenses – or more likely, once I pay off the credit card debt from moving to wherever my next job might be – the student loan is the only debt that I carry.

My parents replied that since that APR over 20 years makes me pay considerably more than the value of the original loan, it would be worthwhile even to take out, say, $10,000 and make a lump-sum payment that would shrink the balance and, therefore, save me some years of interest payments.  According to them, I would then have to go on a repayment plan to my 403(b) alongside the Stafford repayment plan.

The thought of having more unavoidable automatic deductions than necessary turns my stomach, but of course, I don’t yet have a t-t job.  I guess I can understand their logic here, but I don’t have a clear gut instinct what would be best.  Looking ahead, assuming that I might someday have other long-term debt like a new car or a mortgage, what do you suggest?

Disclaimer:  We are not financial planners– talk to a real one about this idea, and a good one (fee-only etc.) if you decide to go forward with it.

Even if you don’t end up with a TT job, you will probably end up with a real job that gives real benefits and a healthy salary.

Our first instinct is NO Don’t do this.  The thing about 401K loans (403b if you stay in gov’t or nonprofit employment) is that if you leave/lose your job, you have to pay them back immediately.  This is only the kind of thing you want to play around with if you already have the money in your savings account just sitting there.  But if you have that money just sitting there, why not *use* it?  It’s not like savings rates or cd rates are particularly high these days.  The worst case scenario sees you declaring bankruptcy.  The best case scenario saves you a little money in interest.

Some other wrinkles if considering bankruptcy as a future option:  It is difficult (nearly impossible) to discharge student loan debt in bankruptcy, so if you’re going to go bankrupt, getting rid of that before other debt might make sense.  However, retirement accounts are also usually protected in bankruptcy proceedings (IRA exemptions are limited, but 403b are unlimited), so taking money from retirement isn’t such a good idea either if you’re planning on a bankruptcy.

5% is pretty high for student loan interest.  That’s not a fun debt to be carrying around.  But it’s also not credit-card levels of interest.  Your monthly payment seems doable, so it’s unlikely to put you into hardship scenarios as long as you’re making enough to pay your rent and feed yourself.  Yes, you’d save money long-term paying it off, but at that level we personally wouldn’t consider adding the risk that comes with 401K loans to do that.

Better:  Once you’re employed with a real job, increase your student loan payments.  That will save you interest and it will decrease your risk down the road.  It won’t save you as much money long-term as paying it off immediately with a 401K loan would, but you also wouldn’t be dependent on your job and your employer either.  If you were stuck in an untenable working environment or if your job were eliminated, you wouldn’t have that huge 401K/403b repayment to make.  At that point you would just stop making the extra student loan payments.

It’s hard to give direct advice for the scenarios with cars and houses without having the numbers.  We will give the standard advice however:  Once you’re employed, contribute to retirement at least enough to get the employer match.  If you can handle it, save 10-20% of your income (including their match) in your work retirement account.  Don’t buy a house unless you have 20% down.  Don’t buy more house than you can afford (and don’t believe the bank calculators about what you can afford– they estimate high).  Don’t buy more car than you can afford (unless the minimum safe option necessary to get you to work is more than you can afford).  Hold on to your car until the maintenance expenses are bigger than the cost of the car, or longer.

We’re betting though, that you’re going to end up getting a non-academic job that will make 23K seem pretty trivial.  (23K is a LOT of money when you’re not making much, but it’s not as bad when you have a high-level salary, so long as you’re able to control your discretionary spending.)  Here’s what we see happening in that scenario:  1st paycheck goes towards moving expenses, living expenses, and a spiffier work wardrobe (as required by work).  2nd paycheck your retirement account on the new job kicks in, you pay extra to your student loan and finish up your remaining moving/living expenses.  Sometime over the next few months you knock out that student loan and start saving for a house and/or new car.  Hopefully your car lasts long enough that its replacement can be paid for in cash.  After the loans are gone and your targeted savings accounts are started and you’ve accrued a couple weeks of vacation, you take a nice relaxing vacation.  When your car finally gives out you replace it.  In a year or two you’ve saved enough for your own condo or townhouse.  Or you’ve found someone to share a house with, get married, and live happily ever after.  If you end up with an academic job, you may decide to start those targeted savings accounts before paying off the loans because it’ll take longer to pay off the student loans.  But you also won’t be spending so much on wardrobe and your expectations will be lower in terms of quality of life.

Grumpy nation, what are your thoughts on 401K loans to pay off student loans?

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21 Responses to “Ask the grumpies: 401(K)/403(b) loans”

  1. Holly@ClubThrifty Says:

    I am not a financial advisor, but I have never heard a good financial advisor advise anyone to take money out of their retirement fund. It seems like a bad idea. Hopefully you can find a way to earn more and kill your debt without jeopardizing your retirement savings.

  2. Linda Says:

    I like the simplest approach to this situation: pay extra towards the student loan debt once the new job (and higher salary) starts. Yes to adding more to the 403(b). If the OP can continue to tough it out for a bit longer with a lower cost of living lifestyle, then it’s possible to knock that debt out completely in a year or perhaps two even while saving for retirement.

  3. Leigh Says:

    Another problem with using a 401(k) loan is that the interest rate isn’t necessarily much better. My 401(k) plan offers a 4.25% interest rate on loans, has a $40 online application fee and a $25 annual fee. You can only take out a loan for 50% of your vested balance, so in order to take out a loan for the entire amount of the OP’s student loans, he/she would need to have $46,000 in the 401(k) plan. If the OP paid off their loans in a year, with the fees, would only save $107.50. That doesn’t seem worth it to me.

    • nicoleandmaggie Says:

      Wow! Thanks for crunching the numbers!

    • Leigh Says:

      Slight correction: you have to leave at least 50% of your vested balance there. So if you have $46,000 in your 401(k), the MOST you could take out as a loan is $23,000. You could still take out $20,000. So, really not worth it on a money scale considering that you can only put $17,500 in per year…

  4. Leah Says:

    Another vote for no. I assume the reason the poster can’t pay extra right now toward student loans is CC debt. I’d double down on the CC debt NOW and get that done — no wishing for a mythical better job. Do with what you’ve got. Then, pay extra on the loans, even if you just start with a few extra dollars a month.

    • nicoleandmaggie Says:

      @Leah
      Dr. Koshary was on a limited contract (that required moving expenses) which just ended. He’s been hinting (but hasn’t said outright) that he’s got a new job (also requiring moving!), but we don’t know what it is.

      He is going to have a better job than the last one. It isn’t mythical.

      • Leah Says:

        Oh, that’s good to know :-) yay for new and better jobs!

        My vote is still a no on a 401k loan. When he starts making more, then I highly recommend living as lightly as possible and really pushing forward on those debts. Painful for a time but his future self will be grateful.

  5. chacha1 Says:

    It’s a TERRIBLE idea. If my father gave me that advice I would immediately assume “well, I guess I will have some financial mess to clean up when he dies.”

    $23K sounds, as noted above, like a lot of money when you aren’t making much money. I paid off more than that in less than two years *after* leaving a job and taking a 30% pay cut. All it took was determination and the willingness to live tight for a while.

  6. Rented life Says:

    This post reminded me of a question I wanted to send you guys for an ask the grumpies: if you have credit card debt should you pay that off completely before setting up and contributing to retirement? (And does your advice change is the employer doesn’t offer a plan and your retirement is just whatever you set up?) My friend thinks you should pay off credit card first, no matter what and then when that is gone you can start saving for retirement. I feel that can do more harm than good, waiting to set up retirement until your debts are gone might have you setting up really late or possibly always having to push it off. Who is “right?”

    • nicoleandmaggie Says:

      That’s a really great question, and even Dave Ramsey caveats this from his regular advice. The answer is there’s some obvious cases where you do it one way, some grey area, and some obvious cases where you do it the other way. So both you and your friend are right (except the “no matter what” part) depending on the circumstances.

      I can elaborate in a future Ask the Grumpies. It’s a fun question.

      • Rented life Says:

        We are a little competitive so I’m not sure he will be happy to hear we are both right. Maybe to break the tie I’ll ask him about pizza.

      • nicoleandmaggie Says:

        hahaha
        I just finished the post, but I don’t know when it’ll go up. I have to see what else is in the queue.

    • Rosa Says:

      I know people like to make decisions on the math, not the feelings, but I have literally never known anyone whose retirement savings plan was “after I pay off this debt” who actually started saving at some point without going through some credit counseling/debt payment nonprofit service. Especially credit card debt, because it’s so hard to get out from under.

      • nicoleandmaggie Says:

        We did…

        I think it is fairly common for people just starting out, actually.

      • Linda Says:

        Yeah, I pretty much did that, too. I didn’t start saving for retirement until I was 31 because 1) I married and had a partner to split the household expenses (rent, utilities, etc.); 2) I had spent the first year of marriage finally paying off the loans from undergrad and the small amount of CC debt I had incurred since undergrad. But since then I’ve been a real rockstar about saving for retirement and not building up CC debt at all. So it can happen! :-)

      • Rosa Says:

        That’s really good to hear. The folks I’ve known who held off because of credit card debt all had a really hard time not adding to the credit card debt, so they didn’t get out as fast as they intended – or they had some other life event (like twins! Or suddenly dependent elderly parents) happen just when they had planned to start seriously saving.

      • nicoleandmaggie Says:

        Well, we didn’t have cc debt, but DH did have pretty high interest on his unsubsidized student loans.

  7. Dr. Koshary Says:

    Wow, thanks for the thorough-going answer, friends! It’s pretty refreshing to hear that my gut instincts are right! Let us hope that you are correct in your predictions for my future employment.


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