This will take a little longer than home mortgages to play out, but could be a much bigger disaster.
The types of people who “used the system” to “flip houses” and buy preconstruction condos (and are now the ones in default in the real estate mess) are the same types of people who would exploit the loopholes in 401(k) plans.
The 401(k) plan is intended to be savings for your retirement – so that we don’t wind up with a country full of poor senior citizens – but the politicians weakened the entire idea by allowing people to borrow using their 401(k) plan as collateral (originally only for an “emergency”, but that was further weakened).
First the rules:
- You can only borrow 50% of your “vested balance”, up to a maximum of $50,000
- You have to repay the loan in 5 years (with some exceptions)
So what some people do is deliberately withdraw their contributions right back out and spend the money – avoiding paying income taxes. Thirty years from now, they’ll deal with the unpaid loan balance – Live for today because we could die tomorrow.
But what happens if the “unthinkable” happens? What if value of the investments in the 401(k) dropped by more than 50%? Well, that could never happen of course. The person with the 401(k) could end up owing more on their 401(k) loan than what the 401(k) is worth. What happens then? Forced repayment of the loan? The 401(k) being liquidated by the trustee to pay off the loan balance? Everyone closes their eyes and just Hopes things work out?
Well, there are 30 years left for the stock market to go back up, so why worry?
For people trying to fend off foreclosure, borrowing against a 401(k) account is an obvious choice as there is no credit check – the “loan” is just you borrowing you own money( right?). You have 5 years to repay the loan back – and what’s the chance things won’t work themselves out in the next 5 years?
Tick. Tick. Tick.