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Tip of the Week: What Is the True Cost of a Plan Loan?

Editor’s Note: This is an occasional feature in the NTSA Advisor. It is drawn from The Source, a book that covers technical, compliance, administrative and marketing aspects of the 403(b) and 457(b) markets. More information about The Source is available here.

Too often, the “cost of a loan” is described as the net interest charged by the provider for the loan. It is very important for participants to understand that the real cost is much larger as it also includes the loss of current interest rates or equity growth on the amount borrowed.

When the net interest cost for the loan and the opportunity loss are added together, it may well make more sense for the participant to borrow the needed funds from another source. Also, there are some important issues to consider regarding loans from 403(b) plans if loan proceeds are used to purchase a principal residence.

Loan interest charges are not deductible on IRS Schedule A unless the loan is actually secured by the residence itself (something that providers and plans generally do not permit). Conversely, loan interest rates are deductible if secured by a mortgage loan on the property!  Participants must understand the advantage of deductibility of loan interest charges when a mortgage loan is used.