Liz Weston: The astonishingly high risk of 401(k) loan
If anyone tells you a 401(k) loan is a cheap way to borrow, they are both right and very, very wrong.
401(k) loan interest rates are low. But the way many Americans repay them spells disaster.
If you stop your 401(k) contributions to repay the loan, borrowing $10,000 today could cost you $190,000, or $1,000 a month in lost future retirement income, if you’re in your 30s. If you’re in your 20s, the loss could double to $380,000, or $2,000 less a month for retirement.
That’s assuming you repay the loan. If you quit or lose your job, chances are high that you won’t, triggering taxes and penalties plus the loss of future retirement income.
Many borrowers like the idea that they’re “paying themselves back” because the interest they pay goes into their 401(k) rather than to a lender. Interest rates on 401(k) loans are typically the prime rate, currently 4.75 percent, or the prime rate plus one percentage point. But that return is likely lower than what the money would earn if it remained invested, and that difference is magnified over the years thanks to compounding.
You can minimize the damage if you don’t reduce your 401(k) contributions during repayment. Let’s say Ashley and Jessica, both 25, take out five-year, $10,000 loans with a 5.75 percent rate. Before the loans, both contributed 6 percent of their $60,000 salaries and got a 50 percent employer match.
Ashley continues contributing $300 each month in addition to her loan payments; Jessica stops her contributions and resumes them after she pays off her loan. About 15 percent of borrowers stop saving after taking out a 401(k) loan, according to Fidelity Investments.
After 40 years:
■Ashley’s nest egg is about $5,700 smaller than it would have been without the loan, according to the National Center for Policy Analysis’ 401(k) loan cost calculator , assuming 7 percent average annual returns. That reduces her monthly income in retirement by about $31 if she buys a 30-year fixed annuity with a 5 percent rate of return.
■Jessica has $381,572 less than if she hadn’t borrowed, or $2,048 less each month in retirement income, if she buys a similar annuity.
In real life, the damage is likely to be somewhere between these extremes.
Most borrowers continue to contribute while repaying loans, although often at a lower rate, according to a study by human resources consultant Aon Hewitt. The average contribution rate of people with loans is 6.2 percent, compared with 8.1 percent for those without.
Also, 401(k) borrowers tend to be older. Loan activity peaks among borrowers in their 40s, according to a study for the National Bureau of Economic Research. The toll for pausing or reducing contributions 20 years before retirement is about one-quarter of what it would be if you cut back when you have 40 years to go.
Regardless of age, borrowers are vulnerable to default. Another study for the National Bureau of Economic Research found that 86 percent of people who left their jobs didn’t pay back their balances within the 60 to 90 days usually required to avoid default. The loan then becomes an early withdrawal, with taxes and penalties typically equaling 25 percent or more of the loan balance.
The bigger cost is the lost future tax-deferred returns. Assuming 7 percent annual returns, each $1,000 withdrawal means $16,000 less after 40 years.
Those are huge tolls. Before you borrow from your 401(k), consider:
■Are you using this loan to live beyond your means? The answer is probably “yes” if this isn’t your first loan, if you’re consolidating credit card debt or if you’re buying something you otherwise couldn’t afford. Fix the spending problem before you create a retirement problem.
■Do you have a plan to avoid default? Ideally, you would have resources such as savings or home equity you could use to repay the loan quickly if you left your job. If you have such resources, the next question is: Why aren’t you using those instead?
■Can you keep up retirement contributions? If you cut back while repaying the loan, be prepared to step up your contributions once you’ve paid off the loan. A good rule of thumb is to add the loan repayment amount to the amount you contributed before the loan and continue contributing that much until you retire.
A reckless 401(k) loan could turn out to be the most expensive money you’ll ever borrow.
Liz Weston is a certified financial planner and columnist at NerdWallet, a personal finance website, and author of “Your Credit Score.” Email: email@example.com . Twitter: @lizweston.
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