How Do 403(b) Loans Work?
For many in the higher ed community, 403(b) plans represent their biggest retirement asset. It really should come as no surprise, either. Employer retirement plan contributions are extremely generous from most colleges and universities. Many individuals will look at borrowing from their plan at some point. In this article, I will cover how 403(b) loans work, the pros and cons, and if you should use one.
What is a 403(b) Loan?
A 403(b) loan is a way to get access to your 403(b) funds by loaning it to yourself. When most of us think of loans, we think of a financial institution giving you a sum of money that you will pay back over a set period of time. 403(b) loans are a way for you to get access to your own money that is normally earmarked for retirement. These funds traditionally wouldn’t be accessible before you are 59 ½. However, with a loan you can access these funds without worrying about any premature withdrawal penalties.
How a 403(b) Loan Works
First things first, not all plans allow for loans. Most do, but you’ll need to check with your HR department or plan provider to know for sure. If your HR contact is unsure, ask for the Summary Plan Description to be sure.
How much can I borrow?
Most plans allow you to borrow 50% of your account’s vested balance, up to a maximum of $50,000. Not all plans will allow you to borrow from your vested company match. Some plans only allow for you to borrow from your vested contributions.
How do I borrow?
One of the reasons 403(b) loans are popular is because the process to get one is simple and easy. If a loan is right for you, you simply call your plan provider and request the loan. As long as the plan permits, you could have the funds in your control within a few days. This is much simpler than having to go to a bank for a loan.
What will the interest rate be?
Typically, the interest rate is the prime rate plus 1%. This means you could potentially get a 403(b) loan with a reasonable interest rate.
How is it paid back?
The term of 403(b) loans normally cannot exceed 5 years. There is a provision that may allow you to repay over 15 years, if you use the loan to buy a home.
Payments of the loan must be made at least quarterly, or more frequently. Some plans allow for a short grace period in which you do not need to make payments.
Once a plan is in place, you’ll pay equal payments over the term of the loan. The payments will come out of your paycheck. This means that you are paying back the loan with after-tax money. These terms are normally non-negotiable once the loan is granted. However, many plans will allow you to pay off the loan in a lump sum if you are able.
Pros of 403(b) Loans
Easy to Obtain - 403(b) loans are much easier to obtain than getting a loan from a local bank or credit union. Complicated loan origination paperwork and extensive credit checks are not needed to get a 403(b) loan.
Low Interest Rate - If you come into a pinch financially, a 403(b) loan might be a good option. The interest rate should be a third -if not a quarter- of what you’d pay on a credit card.
The Interest Builds YOUR Account - in most plans, the interest you pay actually goes into your account. This means your payments to your loan are continuing to build your account. With common bank loans, the interest you are charged goes to the financial institution.
Cons of 403(b) Loans
Double Taxation - When you contribute to your 403(b) plan you are doing so pre-tax. However, when you take out a loan, your repayment comes out of your paycheck post-tax. When you end up taking distributions from your 403(b), you’ll pay income tax on full amount. Repaying a loan with after-tax money and then later paying income tax on your future distributions essentially means you are taxed twice on the loan amount.
Better not default - If you default on your loan, your entire loan amount will be taxed as a distribution, and if you are under 59 ½, you’ll also pay a 10% penalty. If you separate employment while having an outstanding loan, you may be forced to pay right away to avoid default.
Opportunity Cost - Professors are pushing back retirement due to personal finances. With that in mind, taking loans against your 403(b) can stunt the growth of your retirement savings. The loan amount will not benefit from the compound interest that drives the growth of your assets. If you take the loan at the unfortunate time of a down market, your assets likely won’t fully participate in the market's recovery.
Should You Take a Loan from your 403(b) Plan?
The majority of the time, I think it’s a bad idea. Sound financial planning would suggest that you should have anywhere from 3-6 months worth of expenses set aside as a cash reserve. If you come into a pinch, start with cash reserves.
If you have no emergency fund or your only option is to charge a significant amount on credit cards, then I think it’s fine to use a 403(b) loan. This isn’t an ideal scenario but you also don’t want high-interest credit card debt.
The biggest thing to consider is how it will impact your retirement savings. Many times, young people take these loans to buy their first house. I am strongly against this idea. Save money outside of your retirement plan to use on a home purchase. Compound interest within a retirement plan is a young person’s (or any person’s) best friend. It is important not to stunt the growth of your retirement savings. Waiting to invest down the line when you are closer to retirement age makes accumulating significant savings more difficult. Invest early and often when time is on your side.
There you have it! You now know how 403(b) loans work. They don’t make sense for everyone but it is important to be informed should you choose to use one.