Borrowing From Your 401(k)

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THE STASH APRIL 23, 2009

Borrowing From Your 401(k)

It’s often seen as a really, really bad idea, but if you find yourself under a mountain of high-interest debt, typically in the form of credit card debt or auto loans, it might make sense to borrow from your 401(k) to pay off some or all of the loans.

That’s the advice from new research from Federal Reserve economists Geng Li and Paul Smith. There’s one huge caveat though, if you lose your job you have to repay the loan in 90 days or the borrowed amount turns into an early withdrawal with an accompanying penalty fee.

Still, even when you factor in the opportunity costs of foregone investment returns on the borrowed money, Li and Smith say that between 42 and 63 percent of households would be better off if high-interest loans were paid off with borrowed 401(k) funds. Using new data from the triennial Survey of Consumer Finances, Li and Smith find that the average shiftable debt per household comes out to between $6,000 and $8,000, or about 38 to 51 percent of consumer debt.  The numbers are a little less eye-popping if we get another 1990’s stock market boom. Under that scenario the percentage of households benefiting comes down to 20 percent.

The key behind the positive outcome is that interest rates paid on 401(k) loans are low, typically a couple of points above the prime rate. So why don’t more folks do this?

"Households may be rationally averse to the risk of losing their jobs and having to pay back the loan in a short time frame. They may be expecting higher 401(k) returns than the after-tax interest they’re paying on outside loans (or averse to the risk of such a scenario). They may acknowledge self-control problems in spending by walling off in a separate mental account that is unavailable for current consumption. Or, they may simply be making a mistake—they may be confused about the potential advantages of 401(k) borrowing, or they may carry a credit card balance despite their intention to pay off balances every month."

Another problem is that 401(k) loans are not portable across employers. But if conditions permit -- i.e. if your job is relatively secure, and that's a BIG if -- then borrowing from a 401(k) will give you the unique opportunity of owing money to a person you might actually like.

--Zubin Jelveh

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posted in: the stash, business, labor, law, geng li, paul smith

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