In the past year, more people saving for retirement borrowed loans from their 401(k) accounts. According to experts, the rise in borrowing is more due to the impact of inflation.
David Blanchett, a certified financial planner and head of retirement research at PGIM, believes that 401(k) loans, much like credit card debt, serve as leading indicators of economic stress in America.
He added that people are dipping into their retirement savings because they need to cover expenses or repay debts.
Typically, workers can’t access their 401(k) savings before retirement age without facing penalties. However, one exception is loans.
Cathy Curtis, a certified financial planner and the founder/CEO of Curtis Financial Planning in Oakland, California, mentioned, “Increased inflation in the last couple of years has negatively impacted household finances.”
Curtis also added, “If raises have not kept up with the increased cost of living, regular income may not cover all the expenses.”
Inflation, indicating the speed at which consumer prices rise, reached a 40-year high last year but has since decreased notably.
Despite the decline, the average American’s earnings have faced challenges in keeping up, resulting in diminished buying power for many.
In such conditions, investors can borrow against their account balance, and if the loan is repaid correctly, it comes without taxes or penalties. It’s worth noting that not all plans permit such loans, though many do.
Surge in 401(k) Loans
The Plan Sponsor Council of America, a trade group that surveyed employers sponsoring 687 workplace plans, noted an increase in 401(k) loan amounts.
In 2022, the average worker took a $15,000 loan, marking a rise from approximately $10,000 to $11,000 observed between 2018 and 2021.
In the third quarter of this year, about 2.6% of savers, equivalent to approximately 138,000 individuals, borrowed an average of $10,778 from their workplace plans, as reported by Empower, an account administrator.
This percentage is a rise from 2.3% in the third quarter of 2022 and 1.7% in 2020, indicating an increasing trend in borrowing from retirement savings.
Likewise, Fidelity Investments, the largest 401(k) administrator in the country, observed a rise in loans during the third quarter.
Approximately 2.8% of savers, totaling 641,000 individuals, took loans, marking an increase from 2.4% in the corresponding period of the previous year.
Fidelity, analyzing 22.9 million accounts, reported that approximately 17.6% of investors, totaling more than four million individuals, currently have outstanding loans.
This figure has increased from 17.2% in the second quarter and 16.8% in the third quarter of 2022. The firm attributes this growing trend of loans to “inflation and cost of living pressures.”
401(k) Loans are Better Compared to Credit Card Loans
In Q2 2023, Americans resorted to credit cards to meet their expenses, leading to a historic milestone as total credit card debt surpassed $1 trillion for the first time ever.
Economists at the Federal Reserve Bank of New York reported that there are now 70 million more open credit card accounts than in 2019.
Additionally, the bank noted that 69% of Americans had a credit card account in the second quarter, compared to 65% at the end of 2019.
Blanchett suggests that, although households should ideally avoid tapping into their retirement savings prematurely, a 401(k) loan is a “relatively attractive place” to quickly access cash for those facing financial challenges.
Blanchett emphasized, “It’s certainly better than, for instance, credit card debt. While you want to avoid taking on loans if possible, there are better options available than others.”
Unlike other forms of debt like credit cards, individuals who borrow from their 401(k) pay themselves back with interest.
Additionally, 401(k) loan interest rates are typically much lower than the current record-high rates of credit cards, which exceed 21%.
Advisable Case for Utilizing 401(k) Loans
Curtis pointed out that households often utilize 401(k) accounts for down payments on new homes, especially as mortgage rates rise, leading to larger down payments.
This trend results in an increased need for withdrawals from 401(k) accounts.
Freddie Mac data reveals that average rates on a 30-year fixed-rate mortgage have surpassed 7% today, a significant increase from the around 3% levels observed throughout most of 2020 and 2021.
Realtor.com reports that nationwide, the median down payment exceeded $30,000 in Q3 2023, constituting nearly 15% of the average purchase price—a record high.
These figures mark an increase from approximately $22,000 and 12.5% in 2021.
Curtis suggests that 401(k) loans may be sensible in certain situations. For instance, they could serve as a financial lifeline for essential expenses like a medical emergency, helping avoid high-interest debt.
Moreover, a 401(k) loan might be a viable option to cover a down payment when other savings are not readily available.
Curtis notes that the 401(k) loan can be viewed as an investment in an asset with the growth potential.
Conditions Where a 401(k) Loan is Not Advisable
Curtis highlights the risk for individuals with insecure jobs, noting that if a borrower faces a layoff or similar job loss, the 401(k) loan typically requires full repayment within a shortened time frame, varying by plan.
Failing to meet this payment deadline could categorize it as a withdrawal, subjecting the borrower to income tax and tax penalties.
Curtis cautions that withdrawing money from a 401(k) can impact long-term retirement savings.
As the borrowed money isn’t invested in the market, savers may miss out on potential growth.
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