Why 401(k) loans are a bad idea

You forgo po­ten­tial in­vest­ment gains when you bor­row from your nest egg.

Los Angeles Times - - PERSONAL FINANCE - By Liz We­ston Liz We­ston, cer­ti­fied fi­nan­cial plan­ner, is a per­sonal fi­nance colum­nist for Nerd­Wal­let. Ques­tions may be sent to her at 3940 Lau­rel Canyon, No. 238, Stu­dio City, CA 91604, or by us­ing the “Con­tact” form at askl­izwe­ston.com. Dis­trib­uted by N

Dear Liz: You have warned about the risks of a 401(k) loan. In the last 14 years, my av­er­age re­turn has been be­tween 2% and 3%. I am con­sid­ered mod­er­ately ag­gres­sive in my choices of in­ter­na­tional (24%), large and small cap (52%), midcap (16%) and bonds (8%).

It has been an ab­so­lute joke (un­til last quar­ter) so I took out a loan a few years ago and was plan­ning on do­ing it again when the first is re­paid in ap­prox­i­mately two years. I look at it as a 5% re­turn to make my­self a lit­tle some­thing in an un­sta­ble and nasty mar­ket. I see the loan as my best con­sis­tent re­turn op­tion. An­swer: There is some­thing wrong with your port­fo­lio if your av­er­age an­nual re­turn has been that low — and if you think pay­ing re­turns out of your own pocket is a bet­ter op­tion than putting your money to work in the mar­kets.

If you had in­vested in a plain vanilla bal­anced fund 15 years ago, with 60% of its port­fo­lio in stocks and 40% in bonds, your an­nual re­turn would have av­er­aged over 9% (and it would be up 10% in the last year alone). While you wouldn’t have achieved 9% ev­ery year, and your re­turns would vary based on when you bought your shares, your port­fo­lio should have done bet­ter than it has.

It’s pos­si­ble your plan charges higher-than-av­er­age fees or your in­vest­ment choices have higher-thanaver­age ex­penses.

A site called FeeX will eval­u­ate your 401(k) port­fo­lio for free and show you how its costs stack up against other plans. You may be able to move to less-ex­pen­sive op­tions within your plan or press your com­pany to look for lower-cost providers.

The loan you took out de­pressed your re­turns as well. That money was pulled out of your in­vest­ments, so it wasn’t able to grow with the mar­ket. The 5% in­ter­est rate you’re pay­ing may seem cheap, but it’s a bad deal when com­pared to the re­turns the money could have been earn­ing.

New credit scor­ing for­mu­las help some

Dear Liz: I read that the credit bu­reaus have started delet­ing black marks from peo­ple’s credit re­ports. This is good news for me. I have never been late on a house pay­ment in 30-plus years, but my credit is in the low 600s be­cause I co-signed a loan for an ex-girl­friend who has been chron­i­cally late.

An­swer: The records the credit bu­reaus are delet­ing won’t help im­prove your scores.

The three bu­reaus — Equifax, Ex­pe­rian and Tran­sUnion — are re­mov­ing vir­tu­ally all civil court judg­ments and many tax liens from credit re­ports. Tax liens re­sult from un­paid state or fed­eral tax bills and civil judg­ments are court rul­ings from law­suits filed over old debts, un­paid child sup­port, evic­tions and other non­crim­i­nal dis­putes.

Judg­ments and liens caused a lot of dis­putes and complaints about ac­cu­racy be­cause the records were of­ten miss­ing key iden­ti­fy­ing in­for­ma­tion and weren’t reg­u­larly up­dated. The bu­reaus are re­mov­ing the records that don’t in­clude min­i­mum iden­ti­fy­ing in­for­ma­tion such as So­cial Se­cu­rity num­bers or dates of birth in ad­di­tion to names and ad­dresses. The records must also have been up­dated within the pre­vi­ous 90 days.

The deleted records are ex­pected to lead to small credit score in­creases for most of the 12 mil­lion to 14 mil­lion peo­ple who have such black marks on their credit re­ports.

Your is­sue is dif­fer­ent. Be­cause you co-signed, the loan ap­pears on your credit re­ports as well as your ex’s. Ev­ery late pay­ment hurts your credit scores. If your ex had sim­ply stopped pay­ing, your scores would have plunged even more — but then would have be­gun to im­prove as your re­spon­si­ble use of credit be­gan to off­set the de­fault.

Af­ter seven years and 180 days, the de­faulted loan would no longer show up on your credit re­ports or af­fect your scores. Be­cause your ex keeps pay­ing, al­beit late, your credit scores sus­tain fresh dam­age each time. Each late pay­ment also re­sets the clock on how long the neg­a­tive marks show up on your credit re­ports. You won’t be­gin to get re­lief un­til the loan is paid off or re­fi­nanced.

Bryan R. Smith AFP/Getty Im­ages

SOME­THING IS WRONG with a 401(k) port­fo­lio if its an­nual re­turns ranged from only 2% to 3% over the last 14 years. A plain vanilla bal­anced fund would have av­er­aged more than 9% dur­ing the last 15 years.

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