Loans From 401(k)s Are on the Rise As Investors Tap Their Inner Banker

The Wall Street Journal


   Published: June 7, 2011

In spite of decades of advice to the contrary and the improving economy, millions of Americans are increasingly turning to what was once a lender of last resort—their 401(k) plans.

In 2010, about one in seven workers borrowed from a 401(k) plan, according to new data from human-resources consulting group AON Hewitt. Companies that run the plans report double-digit increases in borrowing from 2009: up 14% in Vanguard Group Inc.-run plans; up 11% in plans run by T. Rowe Price Group Inc. Today, almost 30% of 401(k) savers have a loan outstanding, the highest in recent history.

That is too many, says a pair of senators. Last month, Sens. Herb Kohl (D., Wis.) and Mike Enzi (R., Wyo.) introduced the Savings Enhancement by Alleviating Leakage in 401(k) Savings Act (or SEAL Act), which would, among other things, ban products that promote withdrawals, such as 401(k) debit cards. "While having access to a loan in an emergency is an important feature for many participants, a 401(k) savings account should not be used as a piggy bank," Mr. Kohl said in a statement.

Such loans have always been tempting. Interest rates are low, and as both bank and borrower, the employee gets to keep the interest. But lately borrowing from a 401(k) plan has taken on new appeal, as credit-card companies have cut cardholder limits and banks have frozen home-equity lending.

Meanwhile, there are few restrictions on who can borrow from a 401(k). The loan typically can't exceed half the balance, or $50,000, whichever is less, and the investment company that runs that plan typically charges an initiation fee of about $75. But there is no credit check, the paperwork is simple, and the money typically is yours within a week.

What is more, with interest rates so low and the stock market volatile, a 401(k) loan can offer a decent rate of return. An investor who took a $25,000 loan five years ago at 6% interest would have paid himself about $4,000 in interest—about the same return as if he had invested in a Standard & Poor's 500 stock index fund for the same period, without the crash-induced stress. For borrowers who use the money to pay off high-interest debt, the effective return can be greater, thanks to the savings they get by replacing it with the lower-interest loan.

Still, there are enough strings attached to these loans that financial advisers have typically cautioned against them. The loan can stand only as long as you are employed by the company. Lose your job, and the full balance is due, within 60 days, or it is counted as an "early withdrawal," and the borrower will have to pay income tax and a 10% penalty on the balance if he or she is younger than 59½.

"A loan from your 401(k) has the potential to leave deep, deep wounds," says Thomas Muldowney, a financial adviser with Savant Capital Management in Rockford, Ill.

If it is available, a home-equity line of credit may be a better option: the rates are a little higher, but the interest may be tax-deductible, and it isn't tied to the borrower's employment.