I have $12K in credit-card debt due to health issues and a 30% pay cut. Is it finally time to take a loan from my 401(k)?

“My only other debt is my mortgage.” (Photo subject is a model.) - Getty Images/iStockphoto

Dear Quentin,

I have $12,000 in credit-card debt due to multiple home and auto repairs and a large medical bill. Because of a downturn in my industry, my pay was cut 30%. I always try to only spend what I have, paying off my credit card monthly, but this has gotten away from me. I’m getting a second job, but it will be slow. My only other debt is my mortgage.

I’m thinking about taking a loan from my 401(k) to pay it all off. What do you think?

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Indebted

Related:‘I’m in a financial mess’: My income was cut in half. Do I sell my $600K home and kiss my 2.9% mortgage rate goodbye?You have around twice the credit-card debt of the average person in the U.S. - MarketWatch illustration

Dear Indebted,

You’re willing and ready to take action. That counts for a lot.

Not everyone has the capacity to build an emergency fund for six or even 12 months, and especially for $12,000, but this is exactly why we should all do our best to have money set aside for a rainy day. You were hit by an imperfect storm of several unexpected bills and I admire your determination to reduce this balance as quickly as possible.

You actually have three choices: pay off your credit card by cutting back on as many expenses as possible; take a loan from your 401(k); or take out a personal loan. Let’s look at the math first: Paying off your credit card (assuming 21% APR) would cost you $19,440 over the next five years, including $7,400 in interest. Not ideal.

Taking a loan from your 401(k) at 8.25% would result in a $1,500–$2,000 lost opportunity cost, if the interest paid goes back into your stock funds with a 7% return. The reason: You are repaying yourself $14,636 over that five-year period, but also with out-of-pocket post-tax dollars, and you are losing a percentage of the return on your original $12,000 investment.

If you missed a payment, it would not show up on your credit report because the 401(k) loan is not reported to the credit bureaus. However, if you lost your job and were unable to repay the loan for any reason, you would owe income tax on the $12,000 “withdrawal” and a 10% penalty on the outstanding balance if you’re under the age of 59½.

The third choice: Taking out a personal loan, assuming a 12% interest rate, would cost you roughly $16,000 (including $4,000 interest) over the same five-year period. Missing payments would be reported to the credit bureaus, but you are not dipping into your 401(k) to pay for this debt, and it’s likely a lower rate than the credit card.

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Taking a loan from your 401(k)

Based on those numbers alone, it would make more sense to take a personal loan from your 401(k), rather than paying off the credit card and living like a monk. Obviously, those estimates will fluctuate depending on the timeline, but they give you a rough overview of what each option will cost you financially and what the risks entail.

When paying off debts, I favor focusing on credit cards with the highest interest rates (the avalanche method) rather than the lowest dollar figures (the snowball method). The snowball method is a way to motivate people by chipping away at the number of debts they owe, but paying down the highest rate first makes the most sense to me.

I hope your health issues have stabilized, and no doubt the repairs on your car and home will help prevent further, more expensive repairs down the line. It’s hard to know what is in store for the jobs market in the short to medium term, given the prolonged government shutdown and dearth of economic data as a result.

The National Foundation for Credit Counseling is a nonprofit organization that can help you put together a budget and a realistic plan to pay off your debt. A credit union, if you’re a member of one, can help you with that, too. Another nonprofit, American Consumer Credit Counseling, is also there to help people who are in your position.

There are also 12-step support groups, including Debtors Anonymous, which provide a safe space to talk. One of the tenets of 12-step programs is that by being of service to other people, you are also helping yourself, in part by putting your own life in perspective. You have around twice the credit-card debt of the average person in the U.S.

Ridding yourself of this debt is eminently doable.

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Previous columns by Quentin Fottrell:

My siblings don’t earn nearly as much as me. Should my parents leave me less money in their will?

I’m 83 and will have $500K if I sell my house. My estranged wife wants me to join her in Colombia. Do I go?

I’m 53, a single parent with a $1 million home. My boyfriend wants to marry. Am I better off staying single?

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