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American consumers are awash with debt, but borrowing from a 401(k) could help alleviate some of the woes that come with that debt.
The average U.S. household (non-mortgage) consumer debt profile includes $15,611 of revolving credit card debt, and $32,264 of student loan debt, according to a recent NerdWallet article. Add to that the value of other non-mortgage installment loans, such as auto loans and home equity lines of credit, and it is little wonder that debt management is among the most queried topics in online financial advice forums.
Where the 401(k) comes in
Financial planners tend to recommend a two-pronged approach when advising consumers on how to reduce or eliminate debt. The first and most important step is to get disciplined about budgeting. In other words, don’t spend more than you earn, which is no easy task.
The second step is to take advantage of tools that enable consumers to consolidate and refinance at lower interest rates. Common recommendations include home equity lines of credit, transferring credit card debt to issuers offering 0% financing, and consolidating debt through peer-to-peer lending sites, such as Lending Club, Prosper and Best Egg.
Interestingly, the 401(k) loan is an often-overlooked source of funds for debt consolidation and interest rate reduction. According to the Employee Benefit Research Institute, 87% of 401(k) plans offer loan options.
Per IRS rules, plan participants may borrow up to 50% of their vested balance up to a maximum of $50,000. Repayment of the loan must generally occur within five years, and payments must be made in substantially equal payments that include principal and interest, and that are paid at least quarterly.
Loan repayments are not plan contributions. The interest rate of the loan and the repayment schedule are provided by the plan administrator based upon IRS guidelines.
It might not be right for everyone
However, to some financial advisors, the 401(k) plan is the third rail of debt management strategies — a source of capital that should never be touched. There are two basic reasons for this aversion.
The first reason is behavioral. Specifically, for consumers with a proclivity for debt accumulation, the fear is that using a 401(k) to consolidate debt will both imperil the retirement preparedness and, in the absence of disciplined budgeting, simply feed the borrower’s debt addiction. The second reason is the belief that borrowing funds from a 401(k) will cause the consumer to miss out on investment returns.
But is this really sound guidance? According to the Journal of Financial Planning, 401(k) loans actually offer unique advantages relative to the other popular refinancing avenues.
A critical feature that distinguishes 401(k) loans from other financing alternatives is that the interest on 401(k) loans is repaid to the borrower’s own account. Instead of paying interest to the lender, with a 401(k) loan, the loan interest actually adds to retirement savings.
The Journal of Financial Planning also points out that, while some detractors argue that borrowing from a 401(k) is a flawed strategy because interest payments made to a pre-tax account are paid with after-tax dollars, such reasoning is flawed since interest on all other loan sources is also paid with after-tax earnings. In fact, if a person borrows from his or her Roth 401(k), there is no functional difference between the loan interest that is repaid and the participant’s own regular after-tax salary deferral contributions.
Take a look at the market
While both of these articles acknowledge that borrowing from a 401(k) works best when investment returns are low, it is surprising that researchers to date (including the authors of the articles) do not appear to have fully considered the potential advantage that may be gained from avoiding sharply negative investment returns, such as the 50% bear market declines that occurred in the U.S. stock market from 2000-2002 and 2007-2009.
Many plan participants who took 401(k) loans in early 2000 or in mid-2007 undoubtedly and unwittingly side-stepped portfolio declines on the money they borrowed and instead grew their savings by the amount of interest they repaid. Conversely, of course, 401(k) participants who elected to borrow from their 401(k)s at the market nadirs in early 2002 or 2009 likely missed out on the market rebounds over the ensuing years.
From this, we may intuitively conclude that 401(k) loans may be ill-advised when the investment markets are depressed and may be advantageous when the markets are at or near all-time highs.
Naysayers will likely counter that such guidance is akin to market timing. And that brings us to today.
Although it is admittedly possible that investment returns may surge in the years ahead, given that the U.S. stock market has more than doubled over the past six years, we do know for a fact that 401(k) borrowers today are decidedly not withdrawing at a time when values are depressed. An element of timing risk is arguably present in all borrowing decisions, but with the major stock market indices hovering near record highs, common sense suggests that plan participants with high-interest consumer debt may find this to be a positively ideal time to borrow from their 401(k).