Every year, a number of people elect to take a 401(k) loan, an early withdrawal from their 401(k) account, which they have to pay back. Unfortunately, an increasing share of these loans aren’t paid back, as the number of 401(k) loan defaults has risen in recent years.
Sense of borrowing stymied by 401(k) loan defaults
On paper, 401(k) loans make sense. Interest rates are lower than those on credit cards or other types of loans and, unlike any other form of loan, the borrower is actually borrowing money from themselves. They are also paying themselves back, with interest. Unfortunately, a substantial portion of people default on the 401(k) loans they borrow.
According to Time magazine, a survey by Fidelity, one of the largest 401(k) plan administrators, found a 401(k) loan default rate of 22 percent in 2010. A study by researchers from the Brookings Institute and Navigant Economics, according to CNN, found the rate was 17.4 percent between July 2011 and the end of May of this year, compared to 9.7 percent for the year that ended June 2008.
Almost $40 billion lost to 401(k) loan defaults
Though 401(k) loan defaults are almost double the rate observed four years ago in that survey, according to the Los Angeles Times, it was also down from the 401(k) loan defaults rate observed in 2010, which was 19.8 percent.
Those defaults are estimated to result in $37 billion to be lost from the 401(k) accounts of the borrowers. The authors estimate that between 20 and 28 percent of 401(k) accounts have some sort of loan balance outstanding and that $105 billion is borrowed from 401(k) accounts annually. The average amount is $7,860.
According to the Huffington Post, some of the most common reasons noted by investment firm Charles Schwab are for children’s college funds as the applications for a 401(k) loan spike in summer months, down payments on homes and financial emergencies. Indeed, a survey by Aon Hewitt, according to Time magazine, found that 42 percent of people transitioning between jobs cashed out a portion of their 401(k) before rolling it into a new account.
As far as options for personal loans go, a 401(k) loan makes some sense. If everything goes right, according to Forbes, meaning a borrower fully pays it back promptly, it’s an attractive option. The interest rate, according to ABC, is usually well below the APR on credit cards. If used to purchase a home, according to the Huffington Post, the payback period is extended to 15 years. No taxes are imposed, unless the loan is defaulted on.
However, there are some hitches. Money not in a 401(k) account is not earning interest and building a nest egg toward retirement. If a person quits or is laid off or fired with an outstanding balance, they have 60 days to pay the balance in full, or else they fall into default. A 401(k) loan default also means a 10 percent tax on the money from the IRS, as it is a 401(k) withdrawal, which is subject to income tax.
Huffington Post: http://www.huffingtonpost.com/2012/07/25/401k-charles-schwab-data_n_1694950.html