Understanding the Mindset of Participants Who Take Loans

 

Most participants tend to be under financial stress when taking a loan from their 401(k), so the thought of repaying it becomes an afterthought that later adds to their stress, according to a new study. 

Commissioned by Custodia Financial, Greenwald & Associates conducted a survey of 500 plan participants who have taken at least one plan loan and performed in-depth interviews with a subset of the participants to better understand the context around loan-taking, participant education and loan defaults. 
In the resulting report, “Missing Voices: What 401(k) Borrowers Can Add to the Loan Program Conversation,” Greenwald found in 2019 that the vast majority of participants (91%) value the plan’s loan feature as a source of liquidity for financial emergencies. 

The research found that participants are using the loan feature largely for “financial firefighting,” rather than for discretionary expenses such as vacations. The top five reasons participants reported taking a 401(k) loan were to:

• make ends meet (25%); 
• pay off credit card debt (23%);  
• cover out-of-pocket medical expenses (22%);
• purchase a home (20%); and 
• pay for home repairs (17%).

As to loan size, the vast majority are modest, with 76% under $25,000. As such, based on the quantitative results and in-depth interviews, the findings suggest that people borrow only what they need, vis-à-vis the expense they’re facing, and not the maximum allowed (i.e., 50% of the balance or $50,000, whichever is lower).

Education Challenges

Another finding that emerges from the survey and interviews is the significant challenge from an education standpoint. Likely because most participant took out a loan under financial stress, more than half of respondents (55%) believe that it is unlikely that education would have caused them to reconsider borrowing.

Greenwald explains that participants don’t want to be educated about loans when they don’t need one, because it’s not relevant, but when they do need a loan, “they tend to be under financial stress and simply want to access their money as quickly as possible.”

What’s more, participants appear to overestimate the extent to which they understand how the loan feature works and the consequences of default, Greenwald reports. “While there was some variability across these areas, in this self-reported survey, more than 70% of borrowers believe that they understand the limits of what they can borrow, the conditions for paying the loan back, the interest they pay, the taxes and penalties and implications from a credit history standpoint,” the study notes. 

But in the in-depth interviews, Greenwald notes that it became clear that there were significant knowledge gaps. In fact, two-thirds of those interviewed did not even know if they had defaulted on their loan.

Despite the education challenges, the study found that more than 80% of participants are interested in “timely communications to help them better manage their loan after they’ve taken it, when they may be in a better state of mind to learn.”

Stress Reduction

And while most employees with 401(k) loans value the opportunity to borrow from their plans, a significant majority (70%) believe that losing a job would make paying off a loan more difficult. 

Not surprisingly, this worry was correlated in large part with younger participants. Millennial participants ages 25-34 reported the most concern that they could not pay back their loans at all if they lost their job, registering at 69% versus 54% for ages 35-44; 49% for ages 45-54; 28% for ages 55-64 and 44% for ages 65-plus.  

As for the implications for plan sponsors that are committed to improving their employees’ financial wellness, one consideration would be to investigate measures to minimize loan default leakage. “While alternatives such as a $500 or $1,000 emergency fund may help with small emergencies, they may be insufficient for the costlier needs that 401(k) borrowers are addressing,” the study notes. 

The study found that a majority of respondents support the addition of automated loan insurance, ahead of measures such as extended loan repayment programs, and believe that it would reduce their financial stress. Nearly 80% of participants find automated, low-cost loan insurance appealing, and more than two-thirds (67%) of participants said they’d consider contributing more to the plan if their employer were to add loan insurance.