The Perils of 401(k) Loans
What would you get if you asked some of the large investment firms that provide and service 401(k) plans what the most common request was?
Sure, there were questions about account balances or features, and folks who needed help with rollovers or extra copies of paperwork, but the most common request?
Loans. Specifically, loans against 401(k) balances.
According to the Investment Company Institute (ICI), the fund industry's trade organization, 18% of 401(k) participants had one or more loans outstanding at the end of 2006.
Of course many are once-in-a-lifetime deals, for emergencies or down payments, but some use their retirement plan balances as a revolving line of credit. Of course, the consequences for those folks are pretty plain to see when you look at the performance of their accounts: Ugly.
The ups and downs
According to the ICI, most people who take loans have balances of more than $10,000, and the average loan balance is about 12% of the total account balance. Both of those points are somewhat reassuring, but I'm willing to bet that there are still plenty of people taking 401(k) loans who really should be considering other options instead. How to tell? Let's look at the pros and cons of these loans:
But some of the cons are biggies:
- No credit check! If you have a vested balance and don't have other loans outstanding, you'll get the loan.
- The interest rate is often lower than you can get elsewhere, and it goes right into your retirement account.
- Loan payments come right out of your paycheck.
- The process is usually extremely simple (see the bit about "no credit check" above). Some plans might require you to print, sign, and mail in a form; others don't even require that.
- There's no credit check because you're borrowing your own money. And while you're using it, it's not invested in the market earning market-rate returns.
- Unlike your plan contributions, your loan payments are made with after-tax dollars, so there's a proportionately larger hit to your take-home pay. If you need to reduce (or stop) your 401(k) contributions to pay back the loan, your investment will fall even further behind -- and still further if your reduction means you lose out on your company match.
- That interest isn't tax-deductible, because you're paying it to yourself. In fact, it counts as earnings for tax purposes during retirement -- and since it was paid with after-tax money, you get taxed twice on the same dollars.
- The borrowed money isn't in the market earning those nice, fat market-rate returns. (Yeah, I already said that, but it's worth saying at least twice.)
It's very easy to get a 401(k) loan, and usually you have the money in hand fairly quickly. To my mind, that makes a 401(k) loan a good very-rainy-day option -- an emergency source of funds you can use if the emergency is big enough to tap out your regular rainy-day fund. But for something like a new car, or a down payment on a house, exhaust your other options first: nearly all of them will be cheaper than a 401(k) loan in the long run.