Another Reason Not to Plunder Your 401(k)

Jacqui Kenyon
Posted

There are some things which, after you do them the first time, you’re hooked. From jumping off the high dive to sampling the outrageously spicy buffalo wings at one of those real-deal BBQ joints—doing it once is never enough and you keep going back for more.

Turns out, the same is true for taking out loans on your retirement accounts.

Fidelity, owner of the 401(k) accounts of over 12 million Americans, recently examined the habits of what have come to be called “serial borrowers,” those who take multiple loans from their 401(k)s before they reach retirement age.

The research found that once people borrowed from their 401(k)s the first time, they were more likely to keep tapping the accounts in the future, according to The New York Times. Out of the 180,000 borrowers Fidelity studied over the course of 12 years, two-thirds took out more than one loan during that period. 25% took out three or four loans, and 20% came back for five or more.

RELATED: Why You Shouldn’t Withdraw Early From an IRA or 401(k)

Why People Are Borrowing—And How It Can Hurt Them

Taking repeated 401(k) loans can be detrimental to your retirement savings, because as you pay the loan back, you are likely not able to save as much as you would have otherwise. On average, repeat borrowers scaled back their savings by about two percentage points.

There are a number of reasons why people turn to these kinds of loans, and the attractive terms of the loans are at the forefront. The average interest rate on a 401(k) loan is about 4.25%, which is difficult to beat except—possibly—through refinancing your mortgage or taking out a home equity line of credit. Credit card and personal loan rates dwarf the 401(k) loan rate, at 15.31% and 11.41%, respectively. Also, the government doesn’t charge the 10% penalty on loans that it does when you cash out retirement funds early.

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The people who take part in this risky borrowing are what The Times calls “sensible”: Repeat borrowers are in their 40s and 50s and have saved enough to actually have funds to borrow. Fidelity also found that those who had taken out three or more loans made about $80,000 a year.

… But It’s Not All Bad

Some financial professionals aren’t so quick to knock 401(k) loans. For one, it encourages people to save, so that the money is there if the need arises. Plus, as long as they have a plan in place to pay it back, it’s an easy way to borrow money at a favorable interest rate.

At any rate, building up a plush emergency fund to cover unforeseen expenses is likely a better plan than any type of loan, regardless of how low the interest. That way, you can spend more time working on your swan dive and less time worrying about debt.