Financial Planning, Retirement

The Risks Of Serial 401(k) Borrowing

1/19/17 8:00 AM

iStock-493998750.jpgIt is well known than many U.S. households are not saving enough money for retirement but even meeting short-term financial goals appears to be a challenge for Americans. For example, a Consumer Federation of America (CFA) study found that just 63 percent of surveyed U.S. adults said that they have sufficient emergency funds to cover surprise expenses like “car repairs or doctor visits.” Similarly, only 41 percent of consumers recently polled by Bankrate reported that they could pay for a large, unexpected expense with their savings, while roughly a third said that they would instead have to finance the expense on a credit card or borrow from friends and family.

For lower income consumers, regularly setting aside money for an emergency fund can be especially difficult but Bankrate even found that almost half of higher-income households ($75,000+ per year) and college graduates do not have sufficient short-term savings to cover a $500 car repair or a $1,000 emergency room visit. Those are alarming statistics considering that 45 percent of Americans in the Bankrate poll said they or their immediate family had experienced such a major, unexpected expense during the past 12 months, a 2 percentage point increase from the previous year’s survey.

What is worse is that a lack of emergency savings increases the likelihood that a person will have to tap into his or her retirement nest egg early in order to cover a surprise expense. One common way that this can occur is through the use of the flexible loans typically available to 401(k) plan participants. Apart from lowering the total funds that can be invested in the stock market and diminishing the tax advantages, a 401(k) loan can too often lead to serial, non-emergency borrowing. For these individuals it can be very difficult for them to ever get their savings back on track, and few will shop around for more favorable loan options.

Many home improvement stores, for instance, will offer customers low- or zero-interest loans when making large purchases, e.g. kitchen remodeling, but an overreliance on retirement assets may prevent serial 401(k) borrowers from even considering such cheaper alternatives. Moreover, people that borrow from their 401(k) plan will often decrease their overall savings rate immediately after taking out the loan, and various studies have found that many of these borrowers will continue to save at that reduced rate for an extended period of time. An analysis by Fidelity Investments provides a useful example of just how detrimental such behavior can be to one’s financial future:

Consider two employees, age 25, who each earn $50,000 and defer 10% annually in a traditional 401(k).1 The first employee takes a 401(k) loan and maintains his deferrals until retirement and beyond. At retirement, his 401(k) balance is $537,000. We estimate that amount can provide about $2,650 in monthly retirement income.2 The second employee also takes a 401(k) loan, but instead of keeping up his contribution rate, he reduces his deferrals to nothing for 10 years and then resumes his original savings rate. His plan balance at retirement is $396,000—producing an estimated monthly income of $1,960, or $690 less per month than the employee who kept up with his contributions.



Sources: CFA, Bankrate, Fidelity Investments

Post author: Charles Couch