We are contemplating borrowing from 401k as a down payment assistance. Crazy? Lets see. Conventional wisdom says – 
“ Never take money out of your 401k, it doesn’t make sense in any situation”. First, I totally understand that retirement savings are best left for retirement. But conventional wisdom might not be perfect for every single person, for every single situation, right? Personal finance is after all personal. So I decided to check what it would mean for me to take a loan from my 401k for down payment assistance. These are my calculations and my thoughts. I would love to hear from people who have arguments for/against this.
Borrowing from 401k : rules
I wrote a detailed post on the nuts & bolts of the 401k loan – rules, limits, advantages & disadvantages. Check that post here for general information about 401k loans.
Borrowing from 401k : What information do I need from my company to debate this option?
Use the questions below to get information from your employer. The text in italics describes my situation.
- Is it possible to take a loan from my 401k? Mine does.
- How much can I take? 50% of my vested balance.
- What is the interest rate? For my company this is 6%
- What is loan period? As I am planning to take it for buying a home for the first time, the payment period would be 10 yrs. It could be anywhere from 5-15 yrs based on the plan.
- Is there a prepayment penalty? No.
- How long do I have, to repay the money if I leave or am laid off? For my case it would be 90 days.
- What are the loan initiation fees and what about ongoing maintenance fees? For my plan that would be $65 and $0.
- Can I still contribute during the loan period? Yes. My plan allows me to continue contributing and also receive my employer match.
Borrowing from 401k :Why does everyone say that it is a very bad idea?
These are the main reasons why taking a 401k loan is widely discouraged. Especially #1.
- Opportunity costs: The more I borrow, the less money I have to potentially grow for my retirement.
- If I leave my company, I will have to repay the outstanding balance immediately, or within a shortened period of time. If I don’t, it will be subject to ordinary income taxes and a 10% early withdrawal penalty.
- I may pay for the privilege of taking a loan – with initial and ongoing fees such as initial setup and annual loan maintenance fees (depending on the plan provisions).
- If I default on my loan, the IRS considers the outstanding balance a distribution.
- Some loans don’t allow contributions until the money I borrowed is repaid.
- Cash Flow: My paycheck will shrink. I will have the regular 401k contribution taken from my paycheck AND the loan repayment. So I will have less money; which might tempt me to reduce my regular 401k contribution and affect my retirement account indirectly.
So I can never take a loan?
Let me take a look at the disadvantages one by one.
- If I leave my company, I will have to repay the outstanding balance immediately or within a shortened period of time. For my company this period is 90 days (it depends on the plan). So if I have a very stable job or money in other accounts that I can temporarily use it may not be a big problem.
- I may pay for the privilege of taking a loan. This fee is $65 for me and no there are no ongoing maintenance fees for my plan. So I am covered here.
- If I default on my loan, the IRS considers the outstanding balance a distribution. This is similar to #2 I think. So again, if I have a stable job and money set aside for this, in case I have to pay in full, this will be a little less of a problem.
- Some loans don’t allow contributions until the loan is repaid. Luckily this is not the case with my plan. If it didn’t allow contributions, it would definitely be a deal breaker and I would stop here. As it is not the case, I will move on…
- Cash Flow : I will have the same problem if I take a loan from a bank. So if I have enough income and reduce my expenses to cover my regular contribution, loan repayment and my day-to-day expenses this should not be a problem.
Now point #1 as it needs a little bit more analysis.
- Opportunity costs: If we borrow money from our retirement account, we are essentially pulling it out of the market. So it is no longer working for us and doing the magic of compounding.
Let us say I take a $10,000 loan for 5 years (that is what I am estimating I will need and I am planning to repay it as soon as possible). My plan interest rate is 6%. So there are 2 scenarios : (1) I could take a 401k loan @ 6% and lose out on the market growth. (2) I could take out a private loan @ 6% (assuming this rate, I don’t think I can get a rate less than this?) and keep my 401k intact.
For both cases my monthly payment would be $193 and the total cost of the loan would be $1600 over the loan period. Except in one case I will be paying the interest to myself and in the other case to the bank. This argument might not work in boom times but right now the market is down in the dumps. My personal rate of return for the last 2 yrs has been 0.7%, but let me be VERY optimistic and say I will get a 4% market return over the next 5 yrs. If I leave the $10000 in my 401k with a 4% growth rate, I will get $992 and pay $1600 interest on the loan to the bank. So by taking a loan from my 401k instead of the bank, I will come out ahead with an extra $607. This implies that, if I take a loan from myself, under the current the market conditions, #1 is moot for me. Of course, the market might bounce back sooner and the rate of return may go much higher than 4%. Up to a 6% growth rate, I will be fine; if it becomes 8%,then I will definitely lose the advantage and will be better off taking a personal loan and leaving the 401k as it is.
Note: Here is an excellent cost of retirement loan calculator from Vanguard.
So in my case, the only problems would be I should have enough money to pay it off in case I get laid off or have to change my job. Right?
What do you guys think? What did I miss? Is it wise to take a loan against 401k to avoid a second mortgage if needed? Or should it not be touched unless I don’t have any food on the table?
{ 17 comments… read them below or add one }
We took a small loan out against our 401k when we bought our first house, and it worked out fine. I really enjoyed paying the interest to myself.
I think one other thing that could be taken into consideration right now is the market being so depressed. If you are first time home-buyer, you can really get a great deal right now. (Meaning you won’t take a bath on your current home, you can just jump in and buy a house now.) Of course, who knows if this is the bottom of the market, but if it were me, it would be something I would really consider.
Yeah. That is why it is very tempting to buy right now. We don’t know if it the bottom, but it is low enough. If we can push it just a little… Still trying to work out all the options… we could stop contributing to 401k I suppose as an another option, but for some reason I feel better about taking a loan than stop contributing…
Excellent post, well thought out. I’m one of those “stick in the mud” financial advisor types who generally says never borrow from the 401(k). If I was counseling someone who went through this thought process I might relax that a bit. Both a home and the 401(k) are long-term endeavors, so looking at the housing market or the financial markets in the short term as justification is my opinion incorrect. The issue of what happens if one either losses their job or decides to leave for a better opportunity should not be taken lightly either.
We took a loan against our 401k for the closing costs (we had a lousy realtor who told us that the sellers won’t pay anything, so just do it ourselves). But the loan was for 4 years, and it worked out fine.
I wouldn’t take out EVERYTHING you have in order to do this…but as long as you can handle the payment…..go for it.
That is a tough choice between taking a loan or not contribute to your 401k. How long would you have to stop contributing?
We personally took a loan and continued to contribute. That was so long ago…
@Roger. Thanks. That is one of our MAJOR concern. Both of us work. Ideally we would like to get a place that can be paid with just one income, but in Southern CA it has been challenging. We still have to run a detailed analysis on actual numbers including taxes. The answer might be as simple as we are not ready to buy a house. That is okay too. We want to be more prepared than anything else, like some good opportunity pops up, we don’t want to end up buying more than we could afford. So we need concrete numbers.
@Mysti It won’t be everything. For one, we can only take 50% of vested balance. And the other major thing is we would like to be ready for paying it off in case one of us lost our jobs. So it would be something small that we can manage to pay back in like an year (hopefully)
@Kris We would have to stop contributing for at least an year, which means we will miss out on employer matching (we have to contribute to get the match). Ideally we would like to continue everything we do as normal + manage the loan… Ah how I wish I pulled my act together sooner…
Missing the matching would be a big negative in my opinion. How does the housing market look in your area? Is it expected to rebound shortly, or drop?
If you waited to buy the house, how long would it take to get the necessary amount of money together?
Overall, I think the decision has to be based on what you are comfortable with. Everyone has a different comfort threshold, and you have to feel like the decision is right. You can always keep an eye on the market and if a screaming deal shows up, you could see if it is worth it. Or, you could also see if you could get the seller to pay your closing costs or something like that.
I “think” the market is pretty good right now. We will start looking and see if something comes up. We will also look really hard with whatever we already have saved. If nothing comes up for an year or so (by that time we might have a little more money), we can expand our search I guess! There will be too many other expenses we have not budgeted for I expect… oh boy, this is difficult…
I would do it if I could continue contributing and receiving the max company match. Otherwise, I’d use that money you mentioned – the stuff you would use to pay yourself back if you lost your job – and avoid interest altogether.
@BFS Yes we could take from the emergency fund, but the loan sounded better esp. as we are paying a interest for ourselves that is better than the market return. We should run some more numbers I guess. We will still look for a place that we could buy without taking a loan or touching the EF. Its just we live in a crazy place with crazy home prices…
I am not sure there is any job that is truly safe and stable. At any moment any of us could find out that our position has been downsized or our job has been outsourced. In that case, you have to pay back in 90 days. If you have that money available, then why not use that as your down payment?
The other thing to think about, is as the market has been down, your monthly contributions have been buying some pretty cheap stocks. After the loan, you may end up paying yourself back by buying stocks that are now more expensive. The epitome of selling low and buying high.
We’ve borrowed from our 401K for partial payment on some rural property. And, we continued to contribute to the plan to take advantage of the company match. I like the idea of paying interest to ourselves instead of the bank. One of the arguments against 401K loans that I’ve read about in the mainstream press, that you will be repaying the loan with “after-tax” money, is a bit silly. ALL loans are repaid with after-tax money.
You make some very compelling argument here. Good job
Is the interest you pay back to your 401k loan tax deductible if it was a loan for a home? As opposed to a 2nd mortgage, where the interest would be tax deductible….any hidden fees in borrowing from your 401k? Lots of risk for someone to have to stretch so far to get a mortgage in this economy…It sounds like you wouldn’t have a sustainable cushion to soften the financial blow if something happens?
Jesse, 401k loan interest is not tax deductible. I agree it is a stretch, but we do have a good 6 months living expenses in our emergency fund. We are still trying to save 20% before buying a house (we will have peace of mind if we do that, instead of constantly thinking about losing the job and paying back the 401k loan), this was just an exercise to lay out the pros and cons and evaluate this option.
Hi I want to quit my job ,however i have a loan on my 401 k and I need to pay it back . If my next employer offers 401 k can i stiil pay back the loan through my checks or do i have to pay the remainder back? as a defaualt
Geraldine, Unfortunately that is one of the pitfalls of 401k loan even if you voluntarily change job (or get laid off or retire) you will have 90 days to pay the loan back. otherwise it will be treated as a distribution.
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