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Borrowing From 401(k)s
Counterintuitive to conventional wisdom and what other reports and most retirement experts have been warning, a new working paper from the Federal Reserve suggests borrowing from a 401(k) fund may not be such a bad thing. New Evidence on 401(k) Borrowing and Household Balance Sheets by Fed economists Geng Li and Paul A. Smith maintains that, in some circumstances, "401(k) borrowing can, indeed, be advantageous to household balance sheets ... and can be significantly cheaper than other types of borrowing -- particularly credit-card borrowing, which frequently carries interest rates of well over 15 percent." In their introduction, Li and Smith write that "many households eligible for 401(k) loans carry relatively expensive consumer debt that could be more economically financed via 401(k) borrowing. In the aggregate," they write, "we estimate that such households could have saved as much as $5 billion in 2007 by shifting expensive consumer debt" to such defined-contribution loans. "This would translate into annual savings of about $275 per household -- roughly 20 percent of their overall interest costs -- with larger reductions for households that carry consumer debt at high interest rates or who hold larger 401(k) balances," they write. Li and Smith go on to suggest that, while many Americans could benefit substantially by taking out 401(k) loans at much lower interest rates than some bank loans, most are reluctant to even entertain such thoughts due to their aversions to risk, unrealistic expectations, negative publicity and warnings from employers and business publications, and a lack of knowledge. Considering that most employers demand full repayment of 401(k) loans within a short amount of time after the borrowing employee stops working, however, the risk aversion seems well-grounded, says Lisa Arko, a Philadelphia-based senior retirement consultant with Watson Wyatt Worldwide. "It's clear that defaulted loans have long-term consequences," she says. "Most employers demand repayment of 401(k) loans within 90 days of a worker leaving, which could, of course, cause major undue hardship." And what of the skyrocketing number of employees losing their jobs through layoffs in today's economy? "Well, that certainly increases the risk of that loan default happening," says Arko. "This report certainly does stray from the conventional wisdom, that if you have any other option at your disposal, you don't go into your 401(k)," she says. "This [paper] seems to be applicable only to the person who already has high-interest-rate debts -- such that the penalties of taking from your retirement fund are so much less than the interest rates you're paying, it would make sense. "I would have some concern that a paper like this might be misconstrued and might encourage 401(k) borrowing" beyond this narrower application," Arko says. In their paper, Li and Smith propose that "households could benefit from financial education that clarifies the conditions under which 401(k) borrowing could be advantageous for them." For example, they say, borrowers could be presented with a checklist such as the following: 1. If you did not borrow from your 401(k), would you borrow that money from some other source, such as a credit card, auto loan, bank loan or home-equity loan? 2. Would the after-tax interest rate on the alternative, non-401(k) loan exceed the rate of return you can reasonably expect on your 401(k) account over the loan period? 3. Would you be able to make your 401(k) loan payments without reducing your regular 401(k) contributions? 4. Are you comfortable with the requirement to repay any outstanding loan balance within 90 days of separating from your employer, or pay income tax and a 10-percent penalty on the outstanding loan? "If the participant can answer 'yes' to all four questions," they write, "the 401(k) loan could be advantageous to them; otherwise, other options might be better." The authors also suggest changing the current loan-default system so households would be allowed to pay off defined-contribution loans gradually and loans could be made portable across employers -- that is, loan servicing could roll over to the new employer after a job change, along with the account balance. "This would allow participants to continue to repay outstanding balances over time via payroll deduction," the authors write. "Second, former employers could be required to continue servicing loans of unemployed workers after separation," allowing employees with no current employer the chance to continue repaying their loans over time. "Both of these changes would impose some new burdens on employers who offer 401(k) loan programs," they conclude, "but could significantly reduce the risk of 401(k) borrowing to participants. "Given that 401(k) loan programs exist, in part to encourage participation and contributions, it seems appropriate to design them in a way that minimizes financial risks to participants." June 8, 2009 Copyright 2009© LRP Publications |
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