Author: Paul A. Carl, CHSA, CPFA™ Vice President, Retirement Plan Consulting, Registered Representative
When my daughter and I enjoyed lunch at our favorite oriental restaurant recently, we laughed at my fortune cookie message: “Borrow money from a pessimist – they don’t expect it back.” A few weeks later, my daughter asked me to suggest a “pessimistic bank.” She had decided to pursue home ownership and wanted to get loan pre-approval. “The bank not expecting loan repayment would be ideal.” Of course, she was joking because we know that loans don’t work that way.
Whether coincidental or not, a rise in interest rates and a tightening of consumer credit often correspond to an increase in participant loan requests. For 401(k) plans offering participant loans, the loans are relatively easy to obtain. Complete and submit a loan request to the plan administrator who verifies its authenticity and checks the request against governing regulations and the 401(k) loan policy. Based on these factors plus the participant’s vested account balance and the amount requested, the loan is very often turned around within a week or two.
The simplicity of obtaining a participant loan should not, however, drive the participant’s behavior to request a loan. So much more is involved. Before taking a loan, participants should ask themselves the following questions:
- Is this loan for a need or a want? Most often, the first loan request is for a need, such as a car repair. Subsequent loan requests by a plan participant are often to fulfill wants, such as an exotic vacation.
- How will this loan affect my ability to reach my long-term retirement savings goal? Loan rates are fixed for a period of time and the outstanding principal is not invested in the broader investment markets. While not guaranteed, historically the broader investment markets outperform the loan’s interest rate. This difference could materially matter to your account balance at retirement.
- How will the loan affect my net paycheck? Loan payments are payroll deducted and reduce take-home-pay. The extra deduction of the loan repayment often causes a crimp in the participant’s budget and may even cause the participant to suspend or reduce ongoing 401(k) contributions.
- What happens if employment terminates (voluntarily or involuntarily) before my loan is paid off? As mentioned, loan repayments are payroll deducted. Some but very few employers will allow a terminated participant to continue making loan payments outside of payroll deduction. For those who do not, the terminated participant has the choice of paying off the entire outstanding principal plus accrued interest, rolling the loan into the new employer’s retirement plan – an option often not permitted by plan administrators, or taking the outstanding principal plus accrued interest as a taxable distribution (plus 10% penalty if the participant is younger than age 59-1/2).
Does borrowing from your retirement savings seem like a great investment choice to you?
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