One dip into a 401(k) plan often leads to another: Clamping down on repeat borrowing

An interesting dichotomy is taking place in an analysis of 401(k) plan loans. While the likelihood of having a plan loan in any given year is relatively low, more participants had loans at some point between year-end 2016 and year-end 2020.

That’s according to the Employee Benefit Research Institute and Investment Company Institute’s report – “How 401(k) Plan Participants Use Loans Over Time: An Analysis of Loan Activity of Consistent 401(k) Plan Participants, 2016–2020,” which analyzed 401(k) plan loan usage for a sample of 2.2 million consistent loan-eligible 401(k) plan participants who maintained accounts in each year between 2016 and 2020.

Overall, 29% of 401(k) participants in the sample had an outstanding loan at some point in the five years analyzed, compared with 18% at year-end 2016. Repeat-loan 401(k) plan participants represented 16% of the overall sample (55% of the 29% with any loans over the five years).

“With respect to borrowing, a participant’s lifecycle of 401(k) plan loan usage must be examined, since 401(k) plan loans tend to be a multiyear process,” explained Craig Copeland, Ph.D., director, Wealth Benefits Research, EBRI.  “The longitudinal look at loans reveals a higher prevalence of borrowing, including repeat behavior.”

Participants who were observed taking multiple loans between year-end 2017 and year-end 2020 tended to take smaller loans. Among participants with new loans at year-end 2017 who were observed taking an additional loan between year-end 2018 and year-end 2020, about three-fifths had an initial loan of $2,500 or less.

New loans tended to be modest relative to account balances and decreased over time. The median new loan balance at year-end 2017 for participants with loans who did not have a loan balance at year-end 2016 was 16% of the total account balance. By 2020, the average loan balance for those participants had fallen to 4% of the total account balance. The change in the loan share reflects both changes in loan amounts (through payments or new/additional loans) as well as changes in the total account balance (through loan interest payments, contributions, withdrawals, and asset appreciation/depreciation).

“One of the most striking findings from the study is the repeated use of small loans by participants, which appears to be covering expenses in the short term,” says Craig Copeland, Director, Wealth Benefits Research, Employee Benefit Research Institute. “The development of emergency savings accounts by employers is one way that employers can help address this issue of needing to cover immediate expenses. Instead of borrowing form their retirement plan, employees could build up savings in an emergency savings accounts and tap these accounts when needed. SECURE 2.0 allowed for the possibility of incorporating these accounts into retirement plans to take advantage of the possibility of matches and payroll deduction. Employers could also develop accounts outside of the retirement plan, which would lack the tax benefits of the in-plan option but provide more flexibility.”

Related: Save for retirement or build up emergency funds? Helping employees do both

Among 401(k) plan participants with loans, those with larger account balances tended to take smaller loans as a share of their total account balance. At year-end 2017, 64% of participants with new loans and total account balances greater than $100,000 took out 10% or less of their account balance as a loan compared with 16% of those with balances of $10,000 or less.

Similarly, those with smaller accounts tended to be more likely to take a larger share: 57% of those with new loans and balances of $10,000 or less at year-end 2017 took out more than 20% of their balance, compared with 14% of those with balances of $100,000 or more.

“Taking a closer look at new loan activity reveals that some 401(k) plan participants appear to be using 401(k) plan loans to meet modest short-term financing needs,” noted Sarah Holden, Ph.D., senior director, Retirement and Investor Research, ICI.  “Indeed, 401(k) plan participants who were observed initiating multiple loans between year-end 2017 and year-end 2020 tended to take smaller loans.”

Participants who were observed taking multiple loans between year-end 2017 and year-end 2020 tended to take smaller loans. Among participants with new loans at year-end 2017 who were observed taking an additional loan between year-end 2018 and year-end 2020, about three-fifths had an initial loan of $2,500 or less. Among participants with new loans at year-end 2017 who were not observed taking an additional loan, one-fifth had an initial loan of $2,500 or less.

Over the five years analyzed, the increase in loan usage was largest for younger participants or those with lower job tenure as they aged into longer tenure and higher account balances available for loans.

For example, among participants in their 20s at year-end 2016, 7% had outstanding loans at year-end 2016. However, when the five years analyzed are considered altogether, 21% of participants in their 20s had taken out plan loans.