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The Perils of 401(k) Loans

Once upon a time, I worked for a large investment firm that provided and serviced 401(k) plans. The building I worked in included a call center that supported participants in hundreds of plans. The firm required everyone who worked in the building to have some basic call center training, so that we could provide extra help in the event of market turmoil, a natural disaster, or other such crises.

Now, my job didn't really have anything to do with the call center -- I was managing editor of one of the company's in-house magazines, and I spent most of my days doing things like writing and editing. But this was back in 2000, when the market was starting to tumble, and every now and then call volumes would spike and my department would get summoned to the phones.

In the year-plus I worked in that building, I probably spent a total of seven or eight business days on the phones, not enough to make me a grizzled veteran, but enough to give me a pretty solid idea of the kinds of things people called in about. Sure, there were questions about account balances or features, and folks who needed help with rollovers or extra copies of paperwork, but the most common request?

Loans.

Specifically, loans against 401(k) balances. I knew that the majority of the plans we serviced made loans available, but until I spent some time on the phones (and talking to regular members of the phone team) I hadn't realized how popular they were. According to the Investment Company Institute (ICI), the fund industry's trade organization, 18% of 401(k) participants had one or more loans outstanding at the end of 2006.

While many of the loans I helped with were once-in-a-lifetime deals, for emergencies or down payments, more than a few participants seemed to use their retirement plan balances as a revolving line of credit. Of course, the consequences for those folks were pretty plain to see when I looked at the performance of their accounts, right there on the same set of screens: Ugly.

The ups and downs
According to the ICI, most people who take loans have balances of more than $10,000, and the average loan balance is about 12% of the total account balance. Both of those points are somewhat reassuring, but I'm willing to bet that there are still plenty of people taking 401(k) loans who really should be considering other options instead. How to tell? Let's look at the pros and cons of these loans:

Pros:

  • No credit check! If you have a vested balance and don't have other loans outstanding, you'll get the loan.
  • The interest rate is often lower than you can get elsewhere, and it goes right into your retirement account.
  • Loan payments come right out of your paycheck.
  • The process is usually extremely simple (see the bit about "no credit check" above). Some plans might require you to print, sign, and mail in a form; others don't even require that.

But some of the cons are biggies:

  • There's no credit check because you're borrowing your own money. And while you're using it, it's not invested in the market earning market-rate returns.
  • Unlike your plan contributions, your loan payments are made with after-tax dollars, so there's a proportionately larger hit to your take-home pay. If you need to reduce (or stop) your 401(k) contributions to pay back the loan, your investment will fall even further behind -- and still further if your reduction means you lose out on your company match.
  • That interest isn't tax-deductible, because you're paying it to yourself. In fact, it counts as earnings for tax purposes during retirement -- and since it was paid with after-tax money, you get taxed twice on the same dollars.
  • The borrowed money isn't in the market earning those nice, fat market-rate returns. (Yeah, I already said that, but it's worth saying at least twice.)

The upshot
It's very easy to get a 401(k) loan, and usually you have the money in hand fairly quickly. To my mind, that makes a 401(k) loan a good very-rainy-day option -- an emergency source of funds you can use if the emergency is big enough to tap out your regular rainy-day fund. But for something like a new car, or a down payment on a house, exhaust your other options first: nearly all of them will be cheaper than a 401(k) loan in the long run.

To get a ton of expert advice to help you retire well, try the Fool'sRule Your Retirement newsletter service free for 30 days. Your trial includes access to all back issues as well as all current content, planning tools and calculators, and a special members-only message board. Sign up for a free trial and see for yourself -- there's absolutely no obligation.

Fool contributor John Rosevear appreciates your feedback. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (10)

Comments from our Foolish Readers

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  • Report this Comment On April 29, 2011, at 9:40 PM, elhefegato wrote:

    Great article. It answered my question about where the interest you pay on the 401k loan goes. I'm surprised the crooks who run the 401k racket don't keep it. They probably do with my plan! I'll have to pore over the documentation to make sure.

    "The borrowed money isn't in the market earning those nice, fat market-rate returns. (Yeah, I already said that, but it's worth saying at least twice.)"

    - kind of funny time to be so bullish when you look at the date on the article. I'm very interested in taking a loan on my 401k to try and put that money to work elsewhere. What a great time August 2007 would have been to do that. Of course there's that whole hindsight 2020 thing.

  • Report this Comment On May 10, 2011, at 2:40 PM, rayzur9 wrote:

    Hmmm... What if you are using the loan to pay off credit card debt? To save yourself the 25%APR you will be paying on say 10K worth of credit card debt.

    Seems that saving 25% verses the measly returns of the markets right now, would make it desireable, but I have no idea if my plan allows it.

    Just thinkin....

    Best of luck to all !!!!

  • Report this Comment On July 15, 2011, at 8:06 PM, dgsawyer wrote:

    Another drawback - if you leave your job or get laid off you'll have to pay off the loan. That can be tough to swallow if you're out of a job.

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John Rosevear
TMFMarlowe

John Rosevear is the senior auto specialist for Fool.com. John has been writing for the Fool since 2007. A lifelong car nerd, his current daily driver is a Cadillac CTS-V.

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