The following article was written by Travis from Christian Money Mountain.
If you’ve been reading my blog for very long you know that I’ve never had a credit card, and don’t plan on getting one. However, I absolutely love my debit card. How did we ever get by without them? A debit card allows you to make purchases with the card, and the money is automatically deducted from your bank account. It’s just like writing a check, only a lot less hassle. Now, they’ve come out with the 401k debit card. It allows you to borrow from your retirement savings, and more and more companies are offering it.
Don’t be fooled by the name. While it’s called the 401(k) debit card, it actually works like a credit card and debit card rolled into one. It works like a debit card because it lets you access and spend your own money. It works like a credit card because you repay the money over time with added interest and fees. So, lets see you’re basically paying someone else interest for borrowing your own money. This isn’t sounding very good.
When you use a 401(k) debit card, you are borrowing from your 401(k) account. The amount you borrow has to be approved by your employer. Then, once it’s approved, the money is put into a separate money market account which earns dividends. This sounds pretty good, you’re earning money on the money you borrow. However, not as much as you’d be earning if you’re money had remained in the 401(k). Over the last 80 years or so, the stock market earned on average around 10%, while money market funds earned less than 4%.
You are billed each month for what you’ve spent, plus interest and fees. Interest rates are generally tied to the “prime rate” as with traditional credit cards. The 401(k) debit card also carries an additional charge based on the amount of money you borrow, that is paid to the debit card vendor. This just keeps getting better. A minimum payment is due each billing cycle and finance charges are accrued until the entire amount is paid back. If you fail to make a payment for three consecutive months, your loan will be in default and considered a 401(k) distribution. This means, unless your 59 1/2 or older, you’ll have to pay taxes on your loan balance, plus a 10% penalty.
Despite all of this, there are actually some advantages to having a 401(k) debit card.
Let’s look at the pros and cons of the 401(k) debit card.
PROS of 401k debit cards
You can use the funds for any purpose and you don’t have to explain why you need it, or how you intend to spend it. You can’t do this with a regular loan.
You may be able to borrow at a lower rate from your 401(k) plan than you could from a bank.
Since you’re borrowing your own money, there’s no credit check, and you don’t have to worry about creditors coming after you if you fail to repay it.
Part of the interest you pay goes back into your 401(k) account, rather than all of it going to a 3rd party lender.
CONS of 401k debit cards
If you lose your job some employers may require you to pay the outstanding balance within a certain time frame. Others may let you continue making monthly payments as before. You should check with your employer to find out their policy on this before you sign up for a 401(k) debit card.
Repayments to your loans are made with after-tax dollars. This means you will get double-taxed, which wouldn’t happen with a conventional loan.
The fees you pay on a 401(k) loan could be higher than a conventional loan, especially after transaction and maintenance fees.
The interest is never deductible.
Those who opt for the card to meet a cash crunch may have a hard time repaying the loan, and still contributing to their 401(k). This means no company match, and your retirement savings growing much more slowly.
My Conclusion
Make this your last resort. It should only be done in emergency situations. Also make sure you realize the consequences of doing this. You could be looking at a much smaller nest egg, or a potential loan default. Remember, that each time you choose to use the 401(k) debit card, your retirement savings dwindle.
