401(k) loan cheap way to bor­row – but has high risk

The Denver Post - - BUSINESS - By LIZ We­ston

If any­one tells you a 401(k) loan is a cheap way to bor­row, they are both right and very, very wrong.

401(k) loan in­ter­est rates are low. But the way many Amer­i­cans re­pay them spells dis­as­ter.

If you stop your 401(k) con­tri­bu­tions to re­pay the loan, bor­row­ing $10,000 to­day could cost you $190,000, or $1,000 a month in lost fu­ture re­tire­ment in­come, if you’re in your 30s. If you’re in your 20s, the loss could dou­ble to $380,000, or $2,000 less a month for re­tire­ment.

That’s as­sum­ing you re­pay the loan. If you quit or lose your job, chances are high that you won’t, trig­ger­ing taxes and penal­ties plus the loss of fu­ture re­tire­ment in­come.

Many bor­row­ers like the idea that they’re “pay­ing them­selves back” be­cause the in­ter­est they pay goes into their 401(k) rather than to a lender. In­ter­est rates on 401(k) loans are typ­i­cally the prime rate, cur­rently 4.75 per­cent, or the prime rate plus one per­cent­age point. But that re­turn is likely lower than what the money would earn if it re­mained in­vested, and that dif­fer­ence is mag­ni­fied over the years thanks to com­pound­ing.

You can min­i­mize the dam­age if you don’t re­duce your 401(k) con­tri­bu­tions dur­ing re­pay­ment. Let’s say Ash­ley and Jes­sica, both 25, take out five-year, $10,000 loans with a 5.75 per­cent rate. Be­fore the loans, both con­trib­uted 6 per­cent of their $60,000 salaries and got a 50 per­cent em­ployer match.

Ash­ley con­tin­ues con­tribut­ing $300 each month in ad­di­tion to her loan pay­ments; Jes­sica stops her con­tri­bu­tions and re­sumes them af­ter she pays off her loan. About 15 per­cent of bor­row­ers stop sav­ing af­ter tak­ing out a 401(k) loan, ac­cord­ing to Fi­delity In­vest­ments. Af­ter 40 years:

• Ash­ley’s nest egg is about $5,700 smaller than it would have been with­out the loan, ac­cord­ing to the Na­tional Cen­ter for Pol­icy Anal­y­sis’ 401(k) loan cost cal­cu­la­tor, as­sum­ing 7 per­cent av­er­age an­nual re­turns. That re­duces her monthly in­come in re­tire­ment by about $31 if she buys a 30-year fixed an­nu­ity with a 5 per­cent rate of re­turn.

• Jes­sica has $381,572 less than if she hadn’t bor­rowed, or $2,048 less each month in re­tire­ment in­come, if she buys a sim­i­lar an­nu­ity.

In real life, the dam­age is likely to be some­where be­tween these ex­tremes.

Most bor­row­ers con­tinue to con­trib­ute while re­pay­ing loans, al­though of­ten at a lower rate, ac­cord­ing to a study by hu­man re­sources con­sul­tant Aon He­witt. The av­er­age con­tri­bu­tion rate of peo­ple with loans is 6.2 per­cent, com­pared with 8.1 per­cent for those with­out.

Also, 401(k) bor­row­ers tend to be older. Loan ac­tiv­ity peaks among bor­row­ers in their 40s, ac­cord­ing to a study for the Na­tional Bu­reau of Eco­nomic Re­search.

Newspapers in English

Newspapers from USA

© PressReader. All rights reserved.