The Mixed Bag of 401(k) Loans

Christian Weller

CAP Senior Fellow Christian E. Weller testifies before the U.S. Senate Committee on Health, Education, Labor, and Pensions. Read the full testimony (CAP Action)

The growth of retirement savings accounts such as 401(k) plans has raised key policy questions related to getting people to save more money for retirement than they have in the past. Giving employees the option to borrow from their 401(k) plans is, at least in theory, one tool to get people to save more money than they otherwise would in their retirement savings accounts. Current U.S. policy allows employees to borrow within limits from their own 401(k) plans as long as they are employed. Knowing that money will be available in an emergency or for large-scale purchases such as a first home should increase employees’ willingness to put money into their retirement savings accounts. A number of research studies indeed suggest that there is a positive correlation between the ability to borrow from one’s 401(k) plans and the share of earnings that employees contribute to their accounts. And households often borrow from their 401(k) because they have to—because a household member is sick, for example—further underscoring that households indeed rely on their 401(k) savings in an emergency and may have knowingly contributed more to their savings plans than they otherwise would have.

There are downsides to 401(k) loans, though. Taking out a loan during one’s working years can substantially reduce retirement savings—up to 22 percent if a household takes out a loan early in one’s career and only slowly repays the loan. And the link between being able to borrow from a 401(k) loan and contributions is substantially weaker among households that already have a hard time saving for the future because they lack financial sophistication, they are myopic, or they look for instant gratification than other households. Furthermore, having the ability to borrow from one’s 401(k) plan seems to be associated with more overall debt such as credit cards and mortgages, possibly because households feel that they can easily dip into their 401(k) plans if they encounter trouble paying back other loans. That is, increased contributions due to the ability to borrow from one’s 401(k) plan seem to be offset in some instances by households’ characteristics and behavior in other aspects of their finances.

The distinctly mixed evidence on 401(k) loans points to several public policy lessons. First, 401(k) loans fill a critical role for the economic security of households. They tend to rely on those loans for a number of reasons, including paying bills when a household member is ill. Eliminating these loans could thus cause substantial economic hardships for some households.

Second, restrictions on 401(k) loans should remain in place. There is no evidence that households frivolously borrow from their 401(k) loans—the chance of borrowing and loan amounts are moderate, although both have been growing over time. And households typically borrow from their 401(k) loans when access to other forms of credit is costly or unavailable, such as for down payments on a first home or for a college education. Existing loan restrictions, especially on the reasons for taking out a loan from a 401(k) loan, seem to work and policymakers should keep those in place.

Third, there may be room to strengthen the link between a borrowing option from and contributions to a 401(k) plan. The evidence suggests that the link is particularly strong for households, who already handle their finances well, while the link is weaker for households, who seem to struggle in managing their finances in other areas. One possibility may be to make the borrowing option contingent on past contributions. A plan that has a default contribution rate of 3 percent of earnings, for instance, could grant employees the option to borrow from their 401(k) plan if they contributed more than the default contribution rate—four percentage points more, for example (that is, if they contributed at least 7 percent of earnings during the past 12 months or 24 months). The additional required contribution could be lower than this and could be phased in—it is important that the loan option is contingent on additional contributions. The borrowing option would no longer exist if contributions were on average lower than the minimum during the look-back period.

CAP Senior Fellow Christian E. Weller testifies before the U.S. Senate Committee on Health, Education, Labor, and Pensions. Read the full testimony (CAP Action)