Some people can’t seem to stop at just one.
After workers borrow money from their 401(k) retirement account, they may find that it becomes easier to come back for another loan – and perhaps even another. And yet another one after that.
Fidelity, which houses the 401(k) plans of more than 12 million workers, recently studied the behavior of these so-called serial borrowers. It found that this sort of repeat borrowing can put a serious dent in long-term savings, especially if the employees cannot continue to save as much while they pay the loan back.
And that’s what tends to happen with this group. “Once they broke the barrier, they went back and took more and more,” said Jeanne Thompson, vice president for market insights at Fidelity. “They find it’s probably easier than going to the bank to get a loan, so it becomes a bad habit.”
This type of borrowing can be a most attractive alternative to banks: The average interest rate for a 401(k) loan right now is about 4.25 percent (most plans add one percentage point to the prime rate, according to the Plan Sponsor Council of America’s 2011 report, although the formula does vary across plans). With the exception of a mortgage refinance, and perhaps a home equity line of credit, it is hard to beat that rate. Compared with credit cards and personal loans, which now average 15.31 percent and 11.41 percent, according to Bankrate.com, it seems prudent.
The government does not take a 10 percent penalty on the amount borrowed, as it does when a person cashes out of a 401(k) before retirement.
By and large, it looks like sensible people are using this vehicle. Repeat customers, Fidelity found, were typically in their 40s and 50s: people who have saved enough to take multiple loans and who also have a lot of competing needs – college tuition, perhaps, and aging parents to look after.
Thompson also suspects that they’re using the money to pay off medical bills and credit card debt, although call center representatives reported that at least some people were using the money for luxury items like Jet Skis and vacations. A small fraction of borrowers even took out loans as little as $200. On average, someone who took three or more loans over the 12-year period earned $80,000.
But how sensible is it? Fidelity studied the patterns of 180,000 borrowers who were active participants in a 401(k) plan over the last 12 years. Among this group, the majority – two-thirds of employees – took more than one loan over that time period. But 25 percent of borrowers came back for a third or fourth loan, while 20 percent came back to their retirement account five times or more.
Whatever the reason, it’s clear that serial borrowing can permanently impair your long-term savings. The money is no longer invested, so you may lose investment earnings. (When you borrow from a 401(k), the money is taken from your account, without penalty, and you pay yourself back with interest, typically through payroll deductions.)
But while borrowers are paying the loan back, they also tend to dial back their savings by about two percentage points – to about 6.5 percent from 8.4 percent – on average, according to Fidelity. Borrowers didn’t typically resume their original savings rate until two years after the loan was paid off. “It’s a double whammy,” Thompson said. “The money is out of your account and while you are paying it back, you can’t afford to contribute as much.”
There are other hidden costs that many borrowers may not realize they’re paying. You end up paying taxes twice on the interest: The interest you pay yourself comes from after-tax wages, and you pay taxes on that amount again when you withdraw the money in retirement.
Loan defaults obviously have the potential to inflict even more serious damage. The vast majority of those who default – about 10 percent of 401(k) borrowers – do so after leaving an employer (you’re typically required to pay the loan back in full within about 60 days).
Most companies have restrictions in place and allow employees to take only one or two loans at a time (generally speaking, you can borrow half of your account balance, up to $50,000, although some plans impose stricter restrictions).
There’s a reason people are permitted to take the loans in the first place: It encourages more people to save, because the money can be tapped if the need arises. In fact, seasoned retirement experts examined the Fidelity findings, several of them thought 401(k) loans often got a bad rap, and said they didn’t believe the loans should be reflexively frowned upon. Nor were they entirely surprised that borrowers went back for second and third loans. After all, the 401(k) loan is generally a good deal.
“If people have taken a 401(k) loan and have successfully repaid it, they come to discover it is an easy way to borrow cheaply,” said Steve Utkus, principal at Vanguard’s Center for Retirement Research. “They realize, ‘I am going to need another chunk of money for college expenses, and it’s a lot cheaper than the loans I can get privately.’”
The Charlotte Observer welcomes your comments on news of the day. The more voices engaged in conversation, the better for us all, but do keep it civil. Please refrain from profanity, obscenity, spam, name-calling or attacking others for their views.
Have a news tip? You can send it to a local news editor; email email@example.com to send us your tip - or - consider joining the Public Insight Network and become a source for The Charlotte Observer.Read moreRead less