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Plan Well, Retire Well

Saving and investing your money
401k loans

401(k) Loans: Whose Advice Should You Trust?

I was stunned this week when I read a research article contending that taking a loan from your 401(k) is preferable to most other kinds of loans. That flies in the face of what we've all been told over the years.

Two days later, I received my November issue of Consumer Reports Money Adviser, which had a sidebar titled Decision: Borrow from your 401(k)? And it began like this:

How do we hate 401(k) loans? Let us count the ways.

Pretty strong stuff.

The contradictory messages of these two articles, and their being published within a couple days of each other, was just so striking, I decided it was a topic I had to dive into. Who's right? Are 401(k) loans a useful, financially smart tool? Or are they one of the worst financial decisions you can make?

It's a very relevant question, given that around 20% of 401(k) account holders take a loan against their account in any given year; over a five-year period, nearly 4 out of every ten have borrowed against their account, according to a 2014 working paper from the Pension Research Council.

Let's start with the case for using a 401(k) loan.

The article by Tang and Lu, published in the October 2014 Journal of Financial Planning, compares the long-term financial impact of borrowing for an emergency from different types of loans:

1) a loan from a 401(k);

2) a cash advance against a credit card with an interest rate of either 6%, 13.9% or 21.1%, representing an extraordinarily low rate, an average rate, and a higher, but common rate;

3) a high cost loan such as a payday or title loan with an interest rate of 99%; or

4) a home equity line of credit (HELOC) with a starting rate of 4.25% and 0.5% increases each year, either paid off with equal payments over five years, or interest-only payments and a balloon payment at the end of five years.

They assume that the employee has been contributing $1000 each month to his 401(k), and that he will redirect as much of that $1000 as needed to pay off the loan within five years, or as quickly as possible if it cannot be done within five years. Since the $1000 was a pre-tax contribution, an employee in the 15% tax bracket would only have $850 of after-tax money to use to pay toward his loan.

Their conclusion? You'll actually end up with more in your 401(k) if you take the 401(k) loan instead of using a credit card (assuming an average or higher interest rate) or a high-cost loan like a pay day loan. A HELOC or a low-interest credit card loan would be even better – but those aren't available to everyone. For a $10,000 loan, they estimate that a person could save up to $200 per year by choosing the 401(k) loan instead of the more expensive options. Over five years, that's $1000, and the impact will compound even more over time.

There are other considerations about where to borrow the moneys, and the authors mention these:

  • A 401(k) would be a protected asset in bankruptcy. In other words, you would keep your 401(k) even if you filed for bankruptcy. So if there is a possibility that's where you're headed, don't borrow from your 401(k).
  • If you leave your job and you're unable to repay the loan ASAP, the unpaid amount is considered a taxable distribution and may be subject to a 10% early distribution penalty as well. This is a pretty common problem; the Pension Research Council paper says this happens with about 10% of the loans.
  • 401(k) loans often have an application fee and there may be an annual fee. HELOCs also have costs associated with them. Therefore, for a small loan, borrowing at a higher interest rate where you can avoid these fees – such as using your credit card – may save money in the end.
  • 401(k) loans offer fixed interest rates, while HELOCs may have a variable rate.
  • Automatic payroll deductions to repay a 401(k) loan means the borrower does not have to remember – and make themselves – repay the loan as quickly and reliably as they intended.

Let's turn back to the piece in Money Adviser, which takes a position against these loans. What's bad about them? In addition to the risk of leaving your job before the loan is repaid, they also point out:

  • If your employer matches contributions, you'll miss out on those.
  • Opportunity cost: You'll miss any market gains on the amount you borrow from your 40(k), until it is paid back. Depending on your investment's performance during the loan period, that could be a significant loss, or a non-issue.
  • If you did have to pay back your 401(k) loan "in a pinch," such as when you're going to change jobs, you might be forced to sell other investments at bad time, like when the stock market has dropped precipitously.

They say the loan might be a good idea if you 1) know your job is secure; 2) can predict how markets will go; 3) will be 59 ½ during the loan period, and 4) don't have other options, such as home equity." That's a pretty tall list of criteria, especially the one about being able to predict investment returns!

But take a step back, and you realize something. While these two articles start out with statements that sound black-and-white – it's good or it's bad, reading them in their entirety sheds a different light. They actually agree more than they disagree: If you have to borrow money and you don't have other low-cost options, it's worth considering a 401(k) loan.

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