Financial Literacy - Smart borrowing
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Need cash? There's your 401(k) ...

"Among the group of people who have access to these loans, we find that it is people who are already financially strapped who need to pay for economic necessities. They need to cover a spell of unemployment of a family member or they need to pay for medical care or they need to buy a house. They're not going out on shopping sprees," he says.

Pending a decision on the debit cards by Congress, these instruments are actually being adopted by companies in increasing numbers.

"I haven't seen one personally, but I understand that they are growing in popularity, especially at service-related businesses with high turnover," says Fik.

"Its been pitched as a thing for younger employees to make sure they are saving -- like they are not going to defer their income to a savings account unless they can have access to it."

Weller testified before Congress in opposition to the debit cards and points out two main problems with them. First, they make it too easy for workers to access their retirement accounts. Second, they are a bad deal for consumers.

Though the fees involved are similar to a standard 401(k) loan, the company offering the cards -- Reserve Solutions, an affiliate of The Reserve -- also charges additional interest on top of the nominal rate.

"In Congress, when we testified together, Mr. Bruce Bent, the head of The Reserve, said, 'Well, you would pay 5.5 percent interest to yourself and you would pay somewhere between 2.9 (percent) and 3.25 percent' -- so roughly 3 percent to him," says Weller.

That brings the total interest charged to the borrower to 8.5 percent.

"This is a substantial burden. If people really take out a 401(k) loan because they have to, then we shouldn't burden them with extra costs," he says.

Weighing the options

"There are a lot of people out there that would say 401(k) loans are a horrible thing and they would start ranting and raving about them," Fik says. "But people are strapped right now."

ING's Reddy recommends you ask yourself three questions before tapping your 401(k) plan:

3 quick questions
  • Why do you need a loan? If it's to buy a new car, that's not a good reason.
  • Do you need to spend the money now, or can you wait until you've saved more cash? If you do need to spend it now, the third question is:
  • Is there an alternative? For instance, if you need medical services, will the vendor work with you and work out a payment plan? If not, try to find another vendor.

Reddy also recommends exhausting all other sources of savings before taking a loan from a retirement account.

"I've actually encountered people who have taken money from their 401(k) plan, but are still funding their child's college fund," he says.

In emergency situations, the ability to take a loan from your 401(k) can be a good thing.

But it should only be used in situations where the consequences of not taking the loan outweigh the steep price that borrowers pay for taking money out of their retirement account.

What steep price? The authors of the 401(k) loan study say that even a small loan of $5,000 in today's dollars reduces future retirement savings by between 13 percent and 22 percent.

And that is a price that few can afford.

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