Should you take out a loan from your 401(k)?
When we moved to Pennsylvania in 1996, I wanted to buy an old house. After months of searching we found a stone farmhouse close to my new job and in a good school district. There was just one problem: we didn’t know if we could afford it.
We hadn’t been able to sell our house in Maryland, so we had no real estate capital to bring to the table. When our real estate agent saw the asking price, she refused to show us the place because it was out of our price range. She wasn’t wrong.
We went to see anyway. It was a stone house with large mature trees. A light snowfall made the property look like a Currier & Ives print. Our children ran around the yard, jumping into the creek ahead. We had to drive home to put our 7 year old son in dry clothes. But within minutes we had fallen in love with the place.
From the visit I got an idea of how we could afford the property. There was a small cottage, separate from the main house, which could provide rental income which we could then use to cover the mortgage. However, we still needed a large down payment. But I also had an idea of where to find this money. I would borrow from myself.
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First, I incorporated an IRA into my new 401(k) plan at work. Once it was transferred, I borrowed the maximum allowed from the plan, which was $50,000. I would have five years to repay the loan through automatic payroll deductions. The interest rate was prime plus 1%, if I remember correctly.
Plan loans are the most popular 401(k) feature, that is, after employer correspondence. At any one time, one in eight workers has a 401(k) outstanding. Because you’re borrowing from your own savings, you don’t need a bank’s approval. It is also easy to apply. Often, all you need to do is fill out an online form or speak with a representative over the phone.
There remained, however, a snag. Borrowing from the 401(k) went against the advice of my new employer, Vanguard Group. It was not a strict ban. Vanguard allows loans from its 401(k) plan. But the company’s stated position was that money saved for retirement should only be used for retirement.
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This argument has real merit. It’s hard enough for many Americans to save enough for their retirement. We tend to start saving later in our careers. Many workers don’t save enough each month. Why withdraw money from an account that may already be too small?
I knew I was a good saver, contributing as much as possible to the scheme. At the rate I was going, I didn’t think there would be a shortfall in retirement. I didn’t want to miss any more goals. Buying a nice house in a good school district would make my job more rewarding.
Vanguard had other more specific reasons for advising workers against borrowing. The money would be “out of the market” until it was repaid. This meant that I would miss out on gains if there was a spike in stock prices. But at the same time, I could avoid a loss if the stock price fell while I had an outstanding loan. It was a bit of a tossup because it depended on the timing.
Vanguard’s strongest argument was that some borrowers can’t repay their loans, usually because they lose their jobs. This can trigger a financial avalanche. Any remaining balance is due in full, usually within 60-90 days, depending on plan rules. If the borrower cannot make the lump sum payment, the outstanding balance is subtracted from the borrower’s retirement savings. This is reported to the IRS as a taxable distribution, subject to income tax and usually a 10% early withdrawal penalty.
In this worst-case scenario, you could lose your job, default on the loan, lose some of your savings, and then owe the IRS money. About $6 billion in 401(k) savings are lost each year this way, according to a 2015 estimate by researchers at Peking University, the Wharton School, and the University of Pennsylvania’s Vanguard. Their estimate was higher than that found in previous studies.
I could imagine a black swan event like this happening, but not for me. Like most people, I had faith in “recency” – that the current conditions I enjoyed would unfold seamlessly into the future. I trusted that my job was safe and that my health would remain good.
It doesn’t always happen, of course, but it worked out well for us. Looking back I realize I had taken a big bet which luckily turned out OK. Still, I would probably do the same thing again under the same circumstances. Like the idea of borrowing from your 401(k)? Here are four suggestions to make these loans less risky:
Rarely borrow. I’ve only taken out one loan from my 401(k) in my career. If you are borrowing, do it for something vital, not for a luxury purchase or vacation.
One at a time. Some 401(k) plans allow workers to have more than one loan outstanding at any given time. Those who take out two or more loans have a higher default rate. They often borrow from Peter to pay Paul.
Not an emergency fund. Workers who borrow from the 401(k) to pay rent or make car payments could benefit from credit counseling. People who treat their 401(k) as an emergency fund are living too close to the edge.
Make sure your work is secure. Before borrowing, think carefully about your employer’s financial situation and your relationship with your boss. By far the most important thing is not to lose your job while you have an outstanding loan. If you can avoid this, things tend to go well. More than 90% of the plan’s loans are repaid on time.
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This column first appeared on Humble Dollar. It has been republished with permission.
Greg Spears is HumbleDollar’s associate editor. Greg also holds a Certified Financial Planner certificate.