Retirement Account Loans: The New Home Equity Loan?

In the early- to mid-2000s, millions of home owners drained tapped their home equity to pay for home renovations, college educations for their children and, in some cases, even frivolous spending like vacations. But around 2007-2008, when the housing bubble burst, most lenders shut that spigot off.

Now it looks like retirement account loans could be the new home equity loan, according to a recent report, Leakage of Participants’ DC Assets: How Loans, Withdrawals, and Cashouts Are Eroding Retirement Income by Aon Hewitt, which examined records of more than 1.8 million employees across over 110 large defined contribution plans. The report found the percentage of employees with outstanding loans against their retirement accounts has been steadily increasing since 2005, reaching their highest level ever at the end of 2010. “It’s a looming problem that’s not getting enough attention,” says Pamela Hess, director of retirement research at Aon Hewitt.

Some of the findings:

At the end of 2010, 28% of active participants had a loan outstanding — a record high.
The average loan balance was $7860, representing 21% of the account’s value.
29% of participants had two loans outstanding, and 2.5% had more than two loans. Women with lower salaries were more likely than similarly paid men to have an outstanding loan, and women were more likely to have two loans.

Here is how a retirement loan works:

Most defined contribution retirement plans — 401(k)s, 403(b), or 401(a)s, for example — allow employees to borrow against assets in the plan. (You cannot borrow against your IRA.)
The employee must typically repay the loan within five years, usually with monthly withdraws from their paycheck or bank account.
The majority of plans allow employees to use one of these loans toward a down payment on a home. In that case, the repayment period is extended to 10 – 30 years.
Interest is usually charged at a low interest rate (prime plus 1% is most common, says Hess) and is paid back into the account.
There is no credit check, and these loans won’t appear on borrowers’ credit reports.
Except in the case of loans used to purchase a home, borrowers don’t have to justify the loan or explain how they will use the money.

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