That 401(k) Loan May Cost More Than You Realize


It might not be the bank of first or last resort, but it's a bank nonetheless. About one in four investors borrow money from their 401(k), but, while such loans have some benefits compared to other sources of credit, they also can hit your retirement savings in unexpected ways.

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About 22% of plan participants who are allowed to borrow from their 401(k) have such a loan at any given time and half had used a plan loan over a seven-year horizon, according to the authors of a just-published paper, "The Availability and Utilization of 401(k) Loans."

The probability of having a loan follows a hump-shaped pattern with respect to age, job tenure, account balance, and salary, according to John Beshears, a professor at the Stanford Graduate School of Business, James J. Choi, a professor at the Yale School of Management, David Laibson, professor at Harvard University, and Brigitte C. Madrian, a professor at the John F. Kennedy School of Government at Harvard University, who co-authored the paper.

Those likeliest to have a 401(k) loan are plan participants in their 40s, with 10 to 20 years of tenure, earning $40,000 to $60,000, with $20,000 to $30,000 in their 401(k) plan. In 2008, the median amount of these loans was $4,000.

According to David Wray, the president of the Profit Sharing/401(k) Council of America and author of "Take Control with Your 401(k)," more recent studies suggest that one in four employees eligible for a loan have taken advantage of the option, with an average outstanding balance of $8,800.

Some borrow from their 401(k) to buy a home or for home improvements. Others to consolidate bills or pay off loans (sometimes the interest rate on a 401(k) loan is lower than other, more traditional sources of credit). And still others borrow to pay for education, medical bills, weddings, divorces and cars. But no matter the reason, experts say there are several things to consider before borrowing from your plan.

Not without advantages

According to Wray, there are two big advantages to a 401(k) loan. One, if your plan has a loan program, you have the security of knowing that your money is available "just in case," Wray said.

"This means you can comfortably make the maximum contribution commitment to your plan without worrying if you might need those funds later," he said.

And two, loans help prevent you from depleting your retirement savings when a financial crisis occurs. "If your plan offers loans, you will be required to take a loan first before you can take a distribution because once money is taken as a distribution, it cannot be replaced."

Cheap source of credit

If you've already made up your mind to spend a certain amount and the only question is how you're going to finance that spending, a 401(k) loan may be a reasonable source of financing, said Choi, a co-author of the report.

"A 401(k) loan will almost always be a better option than credit-card debt because the former's interest rate is so much lower," he said. The interest rate on 401(k) loans is usually the prime rate plus 1%, though rates vary from plan to plan.

Others agreed. According to Steve Utkus, a principal with the Vanguard Center for Retirement Research, 401(k) loans are a relatively cheap source of credit, compared, for example, to unsecured lines of credit or credit cards. Plus, there are no credit underwriting standards. "You are borrowing from yourself — and therein lies the rub," Utkus said.

By law, the total outstanding principal of 401(k) loans can be no larger than 50% of a participant's vested account balance or $50,000. The authors of the 401(k) study also note that participants are less likely to use loans in plans that charge a higher interest rate, and loans are smaller when plans allow fewer simultaneously outstanding loans, impose a shorter maximum possible loan duration, or charge a lower interest rate.

Besides being a source of cheap credit, Wray said there are other advantages to a 401(k) loan. There's less paperwork to fill out as compared to other types of loans. There usually are no restrictions on how the proceeds are used. Most plans let you borrow for any reason. It's fast. You can receive a loan in mere days, depending on how often your plan processes transactions. And the rate of repayment for your loan may be greater than the rate of return you were receiving on your fixed investment.

Not a free loan

But cheap doesn't mean free just because you're borrowing from yourself, Choi said. "Your 401(k) loan interest payments face double taxation, since they are made with after-tax dollars and then get taxed again when you withdraw them in retirement," said Choi. "And of course, whatever balances you spend now aren't earning an investment return for you."

Other experts share Choi's point of view. "401(k) loans can be an important resource for participants facing financial hardship," said Lori Lucas, a CFA charterholder, an executive vice president at Callan Associates, and chair of the Defined Contribution Institutional Investment Association's research committee.

"The danger is when they are overused for non-essential purposes," she said. "Participants pay back 401(k) loans with after-tax money. And, they become withdrawals if they go unpaid."

Make sure your job is safe

Also, before taking a loan from your 401(k), consider how safe your job is. That's because one of the dangers of a 401(k) loan is that if you leave your job or are laid off, you have to pay the loan off in full within a short period of time, usually 60 to 90 days, said Choi.

The greatest risk with loans is if they don't get paid off, said Stacy Schaus, a senior vice president at PIMCO.

"Any balance you haven't paid off at the end of that time is considered an early withdrawal, and if you're younger than 59 ½, you'll have to pay income tax on that amount plus an extra 10% tax penalty," Schaus said. "Unless your job is very secure and you plan on staying with your employer for the duration of the loan, borrowing large amounts from your 401(k) is risky."

Lucas agreed, and warned about a feature of some 401(k) plans. "While some plan sponsors allow repayment of plan loans after termination, most do not," said Lucas. "Taxes and penalties can take a huge bite out of participants' assets if the loan becomes a withdrawal. Further, withdrawn money is then forever lost to the retirement system."

To be fair, the odds are high that you'll repay the loan, according to Vanguard's Utkus. According to his and other research, 90% of loans are repaid.

Still, one in 10 won't repay their 401(k) loan, more often than not due to a job change. Since you don't know whether you'll be among the one in 10 who don't pay back their loan or the nine in 10 who do, Utkus offered this advice: "If you anticipate changing jobs in the near term, I'd steer away from taking a loan, unless you have money outside the plan to pay off the loan when it becomes due."

Other disadvantages

Dave Tolve, retirement business leader for Mercer's U.S. outsourcing business, said borrowing from a 401(k) can have major consequences — even when repaid on time.

And plan participants should consider the advantages of not taking a loan. For instance, your money can keep growing. Plus, if you take money out of your account, even temporarily, you will miss out on valuable compounding and may end up with a significantly smaller nest egg by the time you retire. And, it is much easier to continue saving without the burden of a loan.

"Many people find it hard to continue making regular 401(k) contributions while repaying their loan — making it even harder to get back on the path to preparing for their retirement," Tolve said.

Wray identified another disadvantage: 401(k) loans are not without fees. Some eight in 10 plans charge a one-time loan fee — of about $72 on average. Another 28% of plans charge an annual service fee of $35 on average. Plus, you may need to get your spouse's permission for a loan.

Bottom line? "The long-term benefits of not touching your retirement savings may far outweigh the short-term benefits of taking the loan," Tolve said. "Although it may seem easy to take a loan from your plan now, there may be other alternatives with lower interest rates that are available to you. Be sure to consider the impact a loan may have on your financial future and explore other options before you borrow from your plan."

The study, "The Availability and Utilization of 401(k) Loans," can be found at this National Bureau of Economic Research website.

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