Considering a 401 (k) loan? Some points to think about

0

There are advantages to borrowing from a 401 (k). Usually, these loans are a cheaper source of debt than alternatives such as credit cards or personal loans. And they don’t require any credit checks or guarantees.

“If you really need the money, it’s hard to say that a 401 (k) loan is bad.” said Lori Lucas, head of the defined contribution practice at investment consulting firm Callan Associates Inc. “If it’s a choice between losing your home and having money in retirement, then the choice is pretty clear. “

But there are hidden costs associated with 401 (k) loans that can reduce, or even drastically reduce, the amount borrowers can save in retirement.

Here are six things to consider:

1) Default risk: Employees can generally choose to borrow up to half of their 401 (k) balance, or $ 50,000, whichever is less. They must then repay themselves, usually over a period of up to five years at an interest rate set by the 401 (k) plan. Often, employers use the prime rate, which today is around 4%. Some shoot an additional percentage point or more.

It’s hard to default on a 401 (k) loan because most employers automatically deduct repayments from the borrower’s paychecks. Where the risk of default arises, however, is when people quit their jobs. In this case, most 401 (k) plans require a borrower to repay the remaining balance within 60-90 days or face a default, which means the employee must pay tax on the loan. income on the remaining balance, plus a 10% penalty if he’s under 59 ½ – and the money can’t go back into a retirement plan.

While most 401 (k) borrowers pay off with interest, about 10% default on about $ 5 billion a year, which can have a significant impact on a borrower’s retirement security, Olivia said. Mitchell, an economist at the Wharton School at the University of Pennsylvania.

Takeaway meals: Consider whether you will stay with your employer for the duration of the loan. If there is a risk that you won’t, have a plan to pay it off in the short term.

2) Loan fees: Many 401 (k) plans charge a loan origination fee which is typically around $ 50, but can reach $ 100 or more, Ms. Lucas said. Some plans also charge an annual loan maintenance fee which often ranges from $ 25 to $ 50.

If you borrow $ 10,000, a creation fee of $ 100 is 1% of your loan balance. But if your loan is only $ 1,000, you pay a 10% fee.

Takeaway meals: Be sure to calculate the fee as a percentage of your borrowing to assess costs.

3) Contribution rate: According to an article published in March by researchers, including Professor Mitchell of Wharton, many 401 (k) borrowers cut their premium rates while paying off their loans by an average of 6% per month, but a third cut their premiums by 10%. % or more. . Of course, the less you save, the less likely you are to have in retirement.

Takeaway meals: Try to maintain your premium rate while paying off your loan.

4) Opportunity cost: One of the great advantages of borrowing from a 401 (k) is that it is a relatively inexpensive way to borrow. But seen in another way, the low interest rate on a 401 (k) loan isn’t such a good deal. For example, if you borrow $ 10,000 at an interest rate of 4%, that money will only increase by 4%, a return that is probably lower than it could have earned on the stock market, which generated in average 7% per year after inflation. since 1926.

“The loan payment looks like a bond yield over time,” said Brigitte Madrian, professor of public policy and business management at Harvard University.

Takeaway meals: If you invest your 401 (k) money mostly in stocks and then take out a loan, expect lower returns.

5) Tax affected: When you pay off your loan, you have to pay the interest on your after-tax salary. But because you’ll have to pay tax on your withdrawals in retirement, you’ll pay twice the tax on interest payments.

Takeaway meals: 401 (k) borrowers cannot avoid this cost, which to most people is not important. But they should be aware of it nonetheless.

6) Alternatives: Because of their low interest rates, 401 (k) loans are often a cheaper alternative to many other forms of debt. But don’t assume you can’t do better. For example, you may be able to get a home equity loan for as little as 3.75% and the interest may be tax deductible, Harvard Professor Madrian said.

Takeaway meals: Evaluate the alternatives.

Write to Anne Tergesen at [email protected]

Copyright © 2020 Dow Jones & Company, Inc. All rights reserved. 87990cbe856818d5eddac44c7b1cdeb8

Share.

About Author

Comments are closed.