The beauty of 401(k) loans

by Stephen Butler

Way back in the early 2000’s, the irony of loans from 401(k) plans was that they were the best performing investment choice for most participants. Anyone who had effectively become their own banker by borrowing from their 401(k) account was earning 7% on their loan as a plan investment, and this was a winner compared to money market rates of about two percent and stock mutual funds that, on average, lost about 35% over a few years.

To review the basics, remember that 401(k) loans can be taken out for any reason at any time. The maximum that can be borrowed is the lesser of half the account balance or $50,000. When someone borrows from his or her account, they have to pay interest on the loan --- a loan then paid back, with interest, into the account over five years. The law states that interest charged on the loan must be “equivalent to that which a neighboring financial institution would charge for the same type of loan.” Every dime of interest paid on the loan is credited right back to the account of the borrower.

Any logical person would ask why we have to borrow money that was ours to begin with. The answer is because roughly one-third of all money in these plans is money that otherwise would have been paid in taxes. In short, our government sees part of it as being their money, which they will sometime be receiving years down stream when we finally take money out of the plan to pay for retirement living expenses. We might say that they too don’t want to be victims of sub-prime lending --- and the whole point of 401(k) plans is to allow people to provide for their own retirement. Therefore, loans are allowed as an element of flexibility, but only in moderation.

When can it make sense to borrow? Financial advisors and pundits like Suze Ormann will say that people should never borrow from their plan. In most cases, this advice comes from people who see loans competing with, and reducing, their asset sales and commissions. I think loans are great. When my kids were both in college, I went right to the $50,000 max.

The real cost of a loan is the opportunity cost of what the money could have earned in other plan investments. When you take out a loan from a plan, you specify from which investments you want the proceeds to be drawn. Over the past four years, a loan earning just 7% could otherwise have been earning 15% in a combination of stock mutual funds. The real cost of this loan would have been the 8% difference --- the “opportunity cost” of the cost of a lost opportunity. A loan during this period was expensive, but who could have known?

What’s the scene today, and how can 401(k) loans help? We have a lot of people paying 25% or more on revolving credit card debt. The credit card companies love it when this happens. In fact, the industry refers to people who pay promptly as “deadbeats” because they generate no profit for the card companies.

Here’s how someone with revolving credit at high rates can become a “deadbeat.” They borrow from their 401(k), pay off all credit card debt (if possible) and then cut up all but the one card they need for convenience.

If there was ever a time when the opportunity cost described above might be low, this could be it. Markets are definitely in a state of turmoil, and borrowing now could protect at least the loan proceeds from what could be some market losses or “corrections.” Paying off credit card debt guarantees a “return” of whatever the annual interest and service fees amount to --- possibly as much as 30%. Moreover, the 401(k) loan repayments will represent a forced savings as the money gets paid back by regular payroll withholding. This is a guaranteed approach to breaking the grip of the credit card industry and offering a clean slate. We can use the experience as an object lesson for avoiding any future excessive debt. Remember Kevin Spacey in the movie “American Beauty” when he looked around his house and said, “This is not life. This is just stuff.” A 401(k) loan mixed with some discipline can lead someone to a space where they are free at last to get a life.

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401(k) Today

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