Should You Borrow From Your 401k?

The last couple posts have been about tapping home equity to purchase investment properties.  Some of my clients just don’t have a lot of equity and have asked about other sources of funds to help with the down payment of an investment property.  One possible option is borrowing from your 401(k).  If you’ve never heard of this option, it’s because it just isn’t done that frequently and, depending on the 401(k) plan, you may not be able to borrow for this particular use.  Borrowing from a 401(k) is more common for the purchase of primary residence, education expenses, or even paying down high interest debt.

Before building your whole plan around borrowing from your 401(k) it is important to check with your plan administrator to see if it is allowed.  It is also critical that you understand the pros and cons.  Don’t forget that your 401(k) is your retirement nest egg, and you are putting that nest egg into possible jeopardy.

Here’s how they work.  Most plans allow you to borrow up to half of your vested balance, but not more than $50,000.  You apply to the company that manages your 401(k) plan, but you don’t have to “qualify”—after all, you’re borrowing money from yourself.  You sign a promissory note and receive the money within a couple of weeks.  The interest rate is usually equal to the prime rate or slightly over, so currently you’d pay 3-4 percent interest.  You then have five years to repay the loan, and most of the time, you make payments through payroll deductions.

Now let’s look at the pros and cons of borrowing from your 401(k):

Pros:

• A 401(k) loan does not appear on your credit report. They are not reported to Experian, and do not become a part of your credit history.
• The interest on these loans is some of the lowest out there—right now, 3-4 percent.
• You’re paying yourself the interest, not some bank.
• You’ll get your money more quickly than if you were using another means of borrowing.
• Since it’s a loan, you will not be charged the 10 percent early withdrawal penalties plus income taxes you would have to pay if you withdrew the money.
• You don’t have to qualify for the loan through the usual long, painful credit approval process, because in effect, you are the lender.
• No assets or collateral are needed to secure the loan.

Cons:

• The biggest con is that you are forfeiting the accrued interest you would earn if your money stayed in the 401(k). Calculated over the long term, it can cost tens (even hundreds) of thousands of dollars in potential gain.
• Unlike a home equity loan, the interest is not tax deductible.
• Some plans do not allow contributions to the 401(k) for the period of the loan.
• If you lose or quit your job, the loan is often due in full in 30-60 days (although some plans are open to renegotiating the terms of the loan. Find out before you sign the papers.)
• If you default on the loan, it is considered a withdrawal and you will owe a 10 percent penalty plus a hefty tax payment. So if you had borrowed $50,000 and couldn’t pay it back, you would have to pay a $5,000 penalty and federal and state taxes that could take another $20,000 of the amount.

It is really important to weigh the pros and cons of using this source of funds to move forward with an investment property.  If you’re just desperate to buy an investment property because your friends or brother-in-law did it, this is probably not the best use of a 401(k) loan, especially if this will be your first investment.  However, if you are a seasoned investor with an outstanding investment opportunity and currently tapped out on other financial resources, then it may be a great time to use your 401(k) funds!