Portion of 401(k) participants with a loan
Source: Investment Company Institute
Many Ohioans who are in need of quick cash are borrowing against their retirement savings accounts, hocking their possessions at pawn shops and taking out high-interest loans from payday lenders, according to a Dayton Daily News analysis.
Loans from traditional financial institutions became harder to acquire as a result of the economic crisis. Widespread job losses and mortgage defaults destroyed many people’s credit scores and saving accounts, and banks tightened their lending requirements while credit-card companies reduced available lines of credit.
Cash-strapped Ohioans who need quick money to cover ordinary or emergency expenses may find that payday lenders, pawn shops and 401(k) loans are convenient.
But consumer advocates urge people to research the benefits and disadvantages of those useful stopgap financial solutions before committing to them.
Borrowing from 401(k) accounts can result in stiff penalties and a loss of some retirement savings. Borrowing from pawnbrokers can result in the loss of prized possessions. And borrowing from payday lenders can be expensive and result in the need to take out additional loans.
“People are not just using these loans for emergencies,” said David Rothstein, project director for asset building with Policy Matters Ohio. “They are using them for basic needs and living expenses a lot of the time, and that is a really expensive way to fulfill those needs.”
About 51 million Americans participate in 401(k) plans, and about 18.5 percent of participants had loans outstanding against their accounts at the end of 2011, according to a report by the Washington, D.C.,-based Investment Company Institute. The portion of 401(k) participants with loans was up from 15 percent in 2006.
Most 401(k) participants belong to plans that offer loans, and most people borrow against their retirement accounts because they have an emergency, need to pay off debt or want money for everyday expenses, according to a recent study from Hal Singer, a managing director at Navigant Economics, and Robert Litan, vice president for research and policy at the Kauffman Foundation.
Loans through 401(k) accounts are usually the last resort for short-term funding for families, and many people take out the loans after attempts to acquire more traditional forms of credit failed, the report states. On average, about nine of 10 loans from 401(k) accounts are repaid.
But some people lose their jobs or transfer to new jobs while the loan is outstanding, and at that point, they have 60 days to repay or they face losing a portion of their retirement savings and having to pay penalties and income taxes on the loan amounts.
Eight of 10 borrowers who leave a job or are laid off default on their 401(k) loans, and the defaults tend to occur to workers who have lower incomes, less wealth and several loans outstanding, said Olivia Mitchell, a professor of business economics and public policy at the University of Pennsylvania’s Wharton School who has studied the issue.
Job losses rose during the economic slump, which contributed to a rise in defaults. The default rate on 401(k) loans was 17.4 percent between July 2011 and May, compared to 9.4 percent between June 2006 and June 2007, according to the report.
Mitchell said fewer people would default if 401(k) loan programs limited the lending to only one loan, and if they allowed participants to continue to repay loans after a job change. Experts urge workers only to borrow against their retirement accounts if the have no plans to change jobs, and they do not suspect their employers are considering layoffs.
Some Ohioans decide to raid their retirement accounts to pay their bills. Others choose to sell or hock their possessions.
After the economy soured, pawn shops saw a marked increase in business, and the industry expanded its customer base as the need for small, short-term loans grew, said Lou Tansky, president of the Ohio Pawnbrokers Association.
“The demand for our services has increased, and everybody is loaning more money and we are seeing new customers,” Tansky said.
In 2009, about 4.7 percent of all households in Ohio had used a pawnshop’s services, and about 21 percent of households that lack traditional bank accounts use them, according to a survey by the Federal Deposit Insurance Corp. Experts their services have undoubtedly become more popular in the last several years.
Pawn shop loans do not require a credit check, but they require collateral, which commonly includes electronics and jewelry. Pawn shops typically provide loans to people with bad credit, entrepreneurs in need of startup funds and small-business owners who cannot obtain bank loans, Tansky said.
“We are a bank for people who have nowhere else to go,” he said.
About 85 percent of people who pawn their possessions repay their loans and reclaim their belongings. But people who are unable to repay forfeit items that are worth significantly more than the money they were lent.
The interest rate at pawn shops is capped at 5 percent, but it is often higher than at banks.
Another popular source of small loans is payday lenders.
About 12 million Americans take out payday loans each year, and about 10 percent of adults in Ohio have used one in the last five years, according to a report released in July by the Pew Charitable Trusts’ Safe Small Dollar Loans Research Project. On average, borrowers across the country take out about eight payday loans every year that are worth about $375 each, and they spend about $520 annually on interest, the study found. Usage of payday loans is higher in Ohio compared to most other states.
Payday loans are lump-sum repayments that are due usually within two to four weeks, and they are packaged and marketed as short-term financial products for emergency expenses, said Nick Bourke, project director of the Pew research project.
But Bourke said the Pew study found the vast majority of loan recipients are using the money for recurring expenses, such as rent, credit card bills and other basic obligations. He said most people who take out a loan are eventually forced to take out additional loans after repayment, because they again find themselves without sufficient income to cover expenses. He said they become caught in a debt cycle.
“The vast majority of the borrowing is sequential,” Bourke said. “With most people, if they do not have $400 today, they are not going to have $400 at their next payday, but they can afford to pay the finance charge again.”
The payday industry disputes this claim, and industry officials said most people use payday advances responsibly and only to meet short-term needs.
Payday loans are often the best and most cost-effective option for people faced with a financial shortfall and who cannot wait for their next paycheck, said Amy Cantu, spokeswoman for the Community Financial Services Association of America. She said payday loans often cost less than it does to pay fees associated with using credit cards, bouncing checks, overdrafting on checking accounts and paying bills late.
But if faced with a need for cash and payday loans were unavailable, most borrowers would either cut back on expenses, delay paying bills, rely on friends and family members for support or sell or pawn their possessions, Pew said. Consumer advocates said oftentimes the best financial decision people can make is to find ways to cut back on spending.
But of course, this is not always an option.
Steven Jackson II, 40, of Trotwood, said when emergency expenses arise, or when he just needs money to pay his bills, he will pawn his video game console, video games and jewelry. Jackson said the pawn shop’s fees are fair, and employees will work with customers to prevent them from losing their possessions in hock.
“They give you a chance to pay the interest on it,” he said. “I have no complaints.”