Which is worse: A payday loan or borrowing against a 401(k)?

Columnist July 30, 2013

This online feature may include questions adapted from my weekly live chat. It’s also an opportunity for me to answer questions I couldn’t get to during the discussion. I may also respond to questions you send by e-mail to (colorofmoney@washpost.com), Twitter (@SingletaryM) or Facebook (www.facebook.com/MichelleSingletary.com).

Michelle Singletary writes the nationally syndicated personal finance column, “The Color of Money.” View Archive

Here are three questions from Twitter Followers

Q: Janine Hopkins @ Jay_Neen asked: Is it really that bad to borrow against 401K in cases of emergencies. I’d rather that than a Payday loan right?

Michelle Singletary: When it comes to your retirement savings in a 401(k) plan, your goal should be to let that money grow so you have funds for retirement. Don’t consider this money as part of your emergency fund. And yes, I would rather you stay away from a payday loan, which is a debt that a borrower promises to repay out of his or her next paycheck, typically in two weeks and typically at astronomical interest rates.

But I understand the temptation to see a 401(k) loan as better than a payday loan. Many people strangled by debt or struggling with unemployment or low wages turn to their retirement plans as the only stash of cash they have. Looking at participants enrolled in its defined contribution plans, Wells Fargo found that there was a 28 percent increase in the number of people taking out 401(k) loans in the fourth quarter of 2012. The average loan balances increased to $7,126 from $6,662 for the same period a year earlier.

Many plans allow participants to borrow from their retirement plan. You can borrow up to 50 percent of the balance of your plan or $50,000, whichever is less.

In the Wells Fargo survey, of the participants who took out loans, the greatest percentage were people in their 50s followed by workers in their 60s. I mention this statistic because it concerns me that people are borrowing from their plan so close to their retirement years.

One argument for the loan is that you are paying back interest to yourself. And that rate is lower than the interest you are paying on your debt. While that may be true, here are two major reasons against borrowing from your 401(k):

-- When you borrow from your retirement account, you lose the possibility of earning money on your investment.

-- If you fail to pay back the loan, you will have to pay taxes on what you took out in addition to a 10 percent penalty for the early withdrawal.

But in the end I get that loans from a 401(k) plan may be your last resort. If it is, take it out only in dire situations, such as a job loss, disability or major illness.

Q: calvin cousins @cc1159er asked: What is the best way to get out of debt?

Michelle Singletary: There are many ways to pay down your debt but the one I suggest and have used with people I help through my volunteer efforts at my church is called the “Debt Dash Plan,” which I wrote about in my recent book, “The Power to Prosper.”

I call it the Debt Dash because this payoff plan is like running a 100-meter dash, a quick race. You start by attacking the debt with the lowest balance to get rid of it as fast as possible.

I’ve found that when people can knock off a bill quickly, it motivates them to press on and aggressively tackle their remaining debts.

On the Debt Dash, list your debts in order moving from the one with the lowest balance to the highest balance. Then you will take any extra money you come up with by reducing expenses or from a second job and apply it to the debt at the top of the list. Make only the minimum payments on the other debts on the list. When you’ve paid off the debt, apply the full payment amount from the first debt to the one with the next lowest balance, adding any extra money you can, until that one is paid off. You continue paying the debts this way until they are all gone.

Q: PLT @Miss_PaigeLeigh asked: Can you share the financial fast?

Michelle Singletary: Several years ago, while volunteering to help people manage their money in a financial program at my church, I developed the 21-day financial fast. I wrote about the fast in my last book, “The Power to Prosper: 21 Days to Financial Freedom.” With the fast, I challenge you to go 21 days without spending money on anything but necessities. You can’t use a credit or debit card.

For 21 days, you can’t go to the mall. No shopping at all, including online. You can’t eat out. No extras at all. You will continue to pay your monthly bills and any other obligations. The point of the fast is to shut down spending that is not necessary. By curtailing your consumption, you might finally see that you can save. You may realize how often you whip out the credit card to pay for things you really don’t need. Even if you are a good money manager, you may find you can do better financially by doing the fast.

For more about the fast read the excerpt the Post ran when the book was first released. You can also get to the link by searching for “The Power to Prosper.”

Follow me on Twitter at @SingletaryM, or connect with me on Facebook at www.facebook.com/MichelleSingletary.com.

Readers may write to Michelle Singletary at The Washington Post, 1150 15th St. NW, Washington, D.C. 20071 or michelle.singletary@washpost.com. Personal responses may not be possible, and comments or questions may be used in a future column, with the writer’s name, unless otherwise requested. To read previous Color of Money columns, go to postbusiness.com.

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