Your Money: One Dip Into a 401(k) Often Leads to Another

After workers borrow money from their 401(k) retirement account, they may find that it becomes easier to come back for another loan — and perhaps even another. And yet another one after that.

Fidelity, which houses the 401(k) plans of more than 12 million workers, recently studied the behavior of these so-called serial borrowers. It found that this sort of repeat borrowing can put a serious dent in long-term savings, especially if the employees cannot continue to save as much while they pay the loan back.

And that’s what tends to happen with this group. “Once they broke the barrier, they went back and took more and more,” said Jeanne Thompson, vice president for market insights at Fidelity. “They find it’s probably easier than going to the bank to get a loan, so it becomes a bad habit.”

This type of borrowing can be a most attractive alternative to banks: the average interest rate for a 401(k) loan right now is about 4.25 percent (most plans add one percentage point to the prime rate, according to the Plan Sponsor Council of America’s 2011 report, though the formula does vary across plans). With the exception of a mortgage refinance, and perhaps a home equity line of credit, it is hard to beat that rate. Compared with credit cards and personal loans, which now average 15.31 percent and 11.41 percent, according to Bankrate.com, it seems prudent.

The government does not take a 10 percent penalty on the amount borrowed, as it does when a person cashes out of a 401(k) before retirement.

By and large, it looks like sensible people are using this vehicle. Repeat customers, Fidelity found, were typically in their 40s and 50s: people who have saved enough to actually take multiple loans and who also have a lot of competing needs: college tuition, perhaps, and aging parents to look after.

Ms. Thompson also suspects they’re using the money to pay off medical bills and credit card debt, though call center representatives reported that at least some people are using the money for luxury items like Jet Skis and vacations. A small fraction of borrowers even took out loans as little as $200. On average, someone who took three or more loans over the 12-year period earned $80,000.

But how sensible is it? Fidelity studied the patterns of 180,000 borrowers who were active participants in a 401(k) plan over the last 12 years. Among this group, the majority — two-thirds of employees — took more than one loan over that time period. But 25 percent of borrowers came back for a third or fourth loan, while 20 percent came back to their retirement account five times or more.

Even though borrowing appears to beget more borrowing, other experts cautioned that these workers may not be lacking self-control, but are simply using the loans to absorb some long-lasting financial shocks, like a spouse who lost a job. Over all, the number of 401(k) loans hasn’t significantly changed: about 10.6 percent of Fidelity plan participants took out new loans in the first three months of this year, which tracks close to the industry average. About 30 percent of all participants who took out two or more loans, or more than 1.7 million workers, still had more than one loan outstanding at the end of June.

“That a lot of people have more than one loan doesn’t mean that they are dysfunctional,” said David Laibson, an economics professor at Harvard who focuses on behavior. “It could mean a lot of things. It could mean that the household is in some financial distress. And for that household it might be a perfectly legitimate response.”

Fidelity didn’t survey the borrowers. It just observed their behavioral patterns. But it did find that the amounts that people borrowed decreased over time, particularly when they had taken at least three loans. “It’s almost a different mind-set versus the people who take just one,” Ms. Thompson posited.

Whatever the reason, it’s clear that serial borrowing can permanently impair your long-term savings. The money is no longer invested, so you may lose investment earnings. (When you borrow from a 401(k), the money is taken from your account, without penalty, and you pay yourself back with interest, typically through payroll deductions.)