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 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 1 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 vacations.
Even though borrowing appears to beget more borrowing, other experts cautioned that these workers may not be lacking self-control but are simply using the loans to absorb some long-lasting financial shocks, like a spouse who lost a job.
“That a lot of people have more than one loan doesn’t mean that they are dysfunctional,” said David Laibson, an economics professor at Harvard who focuses on behavior. “It could mean a lot of things. It could mean that the household is in some financial distress, and for that household it might be a perfectly legitimate response.”
But how sensible is it?
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 2 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.”
“Taking one loan out and paying it back and maintaining your deferral rate isn’t going to have a significant impact,” Thompson said. “It’s when you start taking multiple loans that will.”
Still, there are other hidden costs. 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).
But there’s a reason people are permitted to take the loans in the first place: If they can tap into the money when a need arises, they’re more likely to save. In fact, several seasoned retirement experts say 401(k) loans often get a bad rap, and they don’t believe the loans should be reflexively frowned upon.
“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.’ ”