What Is Better to Pay Off First: A 401(k) Loan or Credit Card Debt?

by David Rodeck, Demand Media
    The taxes on a defaulted 401(k) loan outweigh the fees of missed card payments.

    The taxes on a defaulted 401(k) loan outweigh the fees of missed card payments.

    When you owe money on a couple of types of loans, the easy solution would be to pay off the loan with the highest interest rate. However, when you owe money to both your 401(k) and your credit card issuer, the decision isn't this simple. When you miss payments on either of these accounts, you get hit with a number of extra costs on top of interest. You need to consider all these factors to decide which account you should pay off first.

    Fees

    Credit cards charge higher interest rates than 401(k) plans so it is more expensive to owe money on your credit card. Also, if you miss a payment on your credit card, your company could charge you a penalty fee plus raise your interest rate. On the other hand, if you don't pay your 401(k) loan on time, the IRS will consider the loan a withdrawal. You will owe income tax plus an extra 10 percent early withdrawal penalty on the entire amount. This will be more expensive than the credit card fees.

    Credit Score

    Your credit score is a measurement of your safety as a borrower. When you make your credit card payments on time, your score goes up. If you miss a payment, your score goes down. A lower credit score means creditors will be less likely to lend you money and will charge you a higher interest rate. A 401(k) loan has no impact on your credit score. You don't need to pass a credit check to take out a 401(k) loan, and missed payments will not drop your score.

    Retirement Planning

    If you don't pay your 401(k) loan on time, it sets back your retirement plan in a couple of ways. When you default on your loan payments, you are frozen out of your 401(k) for six months. You won't be able to add money or receive matching contributions from your employer. Once you're back in the plan, you will be allowed to make only regular contributions and won't be allowed to repay the loan, which was converted into an early withdrawal. Depending on the size of your loan, it could take you years to get back to your original balance.

    Strategy

    The best option for minimizing your fees and keeping your borrowing options open would be to first make the minimum payment on your credit card. This heads off missed payment fees and protects your credit score. The next step would be to pay down the 401(k) loan. The withdrawal taxes and penalty are more expensive than the credit card interest rate. Once your 401(k) loan is paid off, you can finish paying down your credit card debt.

    About the Author

    David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.

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