In July 2008>, Sen. Charles Schumer (D., N.Y.) and Sen. Herb Kohl (D., Wis.) presented legislation to limit the number of loans savers can take from their 401(k) accounts and to ban the use of debit cards to access the funds.
"The point is that 401(k) and similar defined contribution plans were created to ensure that people would have adequate savings for retirement, not as a source of credit to use casually," Kohl said at the time.
With great respect to the senators, who surely mean well, Congress has overspent the nation's tax receipts every year since 2001, more than doubling the gross national debt, adding to it about $75,000 per household. Perhaps the people should decide for themselves how best to handle their finances.
The evidence suggests more Americans, not fewer, should consider 401(k) loans.
About half of 401(k) plans have loan provisions, and more than 90% of large plans with more than 10,000 participants have them. Most plans place no restrictions on how borrowed funds are used, but relatively few allow loans only for things like house purchases, educational expenses and medical bills. Loans are limited by law to 50% of vested account balances or $50,000, whichever is less, but a few plans use stricter limits. Funds must be repaid over no more than five years (longer if used for a home purchase), and plans must charge a fair rate of interest (usually pegged to a floating rate), which borrowers effectively pay to themselves.
There are several downsides to 401(k) loans. First, money borrowed from an account doesn't earn a return inside the 401(k) until it's repaid (but may earn one outside of it). Second, borrowers pay taxes twice on the interest they pay -- once when it's earned as income and again when it's taken out of the plan after retirement. Third, loans that aren't repaid on time count as early withdrawals and are taxed accordingly. Repayment rates on 401(k) loans are usually excellent because workers have payments deducted from their pay, but after a job loss, loans must often be repaid within 60 to 90 days.
Now for the upsides. First, loans from 401(k) accounts are often cheap compared with the options. Banks currently charge double-digit rates on credit card, personal and business loans. (The Federal Reserve has slashed core interest rates to near zero and held them there for 13 months, saying it wants to spur lending, but banks seem to have lowered only the rates they pay on savings deposits not the ones they collect on consumer loans.) Many 401(k) plans charge only 5% or so on loans at the moment. Second, 401(k) loans are available to many consumers who can't qualify for bank loans. Third, there are far more ways to use funds outside of a 401(k) than inside it, and some of them have far better returns.
How good of a deal a particular 401(K) loan is depends largely on three things: 1) the interest rate, 2) the job security of the borrower, and 3) how wisely the borrower uses the money. It's easy to assume that, left to their own devices, plan participants will squander their savings on frivolous shopping, but there's little evidence to support that. A study published last fall found that the share of eligible 401(k) participants who take loans has changed little over the past decade. It's about 15%. That's likely because the two main factors that affect the likelihood of 401(k) loans -- the level of economic hardship and the size of account balances -- change inversely to each other. In other words, the more people need the money, the less money there is. (The exception, perhaps, is now. Recent stock declines notwithstanding, share prices have rocketed nearly 60% higher from their March 2009 lows, but during that same time, unemployment has worsened; at the moment, hardship is great and 401(k) balances are decent.)
Moreover, the same study found that in 2007, American households could have saved $5 billion simply by shifting high-interest consumer debt to 401(k) loans. That's about $275 for each household that would have benefitted.
The point here isn't that a 401(k) loan is right for you. It's that you can probably figure it out for yourself without help from Congress and without morally loaded arguments. Two years ago, the Center for American Progress published a report on 401(k) loans titled "Robbing Tomorrow to Pay for Today." Again, they mean well. Suppose, however, that a 401(k) participant calculates that using a 5% loan to pay off 24% credit card debt is simply a good deal. Or, suppose he decides that stocks are too expensive (especially in the market-value-weighted index funds in his plan) and that money market rates are too low (especially considering the risk of inflation brought on by all that government borrowing). So he decides that, by using a 401(k) loan as a down payment on real estate or a small business, he can buy better returns and more inflation protection at lower prices. Is he still "robbing tomorrow" or is he just thinking strategically today?