Considerations for taking a 401k loan to use as a down payment
Unless you have some other lucky option like a no-money-down mortgage backed by the VA or something, chances are the 20% down payment on a house is a huge obstacle. In this post we’ll look at some of the pros and cons of taking a 401k loan as a down payment (using me as an example).
First, what is a 401k loan?
We’re making a pretty big assumption right off the bat: that you enough money in a retirement account (401k, 403b, Civilian TSP, etc) to even consider taking a loan against it. Even if you don’t (yet!), it’s worth reading this post because it may factor in to how much you start saving/investing and where you do it.
I’m going to use my personal experience so some of the specific numbers may differ, but the idea is always the same. It works like this: Say you have $100,000 in your 401k. Normally, you wouldn’t be able to touch that money until retirement without paying significant early withdrawal penalties and taxes. What if you want to buy a house that costs $250,000, but you don’t have 50k lying around to make the 20% down payment and avoid PMI (which you definitely want to do)? You generally have the the option of loaning *yourself* that money out of your 401k, paying yourself back with interest and avoiding any penalties/taxes (specific rules vary by employer).
In my case, the employer allowed a loan of up to 50% of my 401k value, and it had to be paid back over 5 years in equal installments, at a 4.5% interest rate.
What are the benefits of a 401k loan for a down payment?
I think they’re mostly self-evident, but let’s enumerate them to see if I missed anything:
1. You get access to money you need to buy a house (avoiding PMI)
2. The interest that you’re paying goes back to you!
3. It’s generally pretty easy. I went online, checked a few boxes, and they sent a check within the week
What are the drawbacks?
Here’s where it gets complicated, and where it’s up to you to weigh your options.
1. You may be required to pay it back in full immediately if you leave that employer or face penalties/taxes as if you took an early withdrawal [1]
2. There’s a real opportunity cost at play here, because that $43,215 I took out would have otherwise been invested in the stock market. Instead of whatever potential gains that offered, the $43k earned a fixed 4.5% return because that’s the interest rate set by my employer (and paid by me). See the specific numbers in the next section.
3. It will factor into the debt picture used by your lender. Even though I’m paying myself, that $895/mo was another line item just like a car payment.
[1] While all of the official documentation for my plan (and all of the warnings on personal finance websites) drove this point into the ground, it’s a little more complicated. In fact, not a year after taking this loan I wanted to move on but I didn’t have $40k in cash to pay back the loan. One of my friends in HR pulled me aside and quietly assured me that although they say this is the policy, it’s actually not. All I have to do is keep the same auto-draft setup and I can leave anytime. Sure enough, I’ve worked for 2 different companies and am now self-employed and nothing about my loan has changed. Not saying it’s true everywhere, but for this [large government contracting] company, it was just a scare tactic to keep workers from leaving.
What was my actual opportunity cost of that money?
Because I pulled the $43,000 out of my 401k, it was no longer invested in stocks, and I was instead getting a fixed 4.5% return (simple interest – the annualized rate of return is actually 2.53%). But we know that opportunity cost is when you spend/invest in one option instead of the other. So what if I had left the money in my 401k?
Using a historical investment calculator, I see that if I had invested $43,000 into a simple dow jones index fund at the end of 2016, the closing value at the end of 2020 would have been $66,927 ($23,712 in gains for an 11.5% annualized rate of return).
That means instead of $23,712, my “gains” were $4,549 (the amount I paid myself in interest). So the opportunity cost of this 401k Loan works out to me “missing out on” $19,163. Because it’s always more complicated…the house has appreciated by roughly $25,000 in the last 4 years, so if we had waited & saved up the money instead of a 401k loan…we’d always be chasing our tail.
If we had 5% down, the PMI would have cost us $11,845, bringing the real, actual, no-bullshit opportunity cost to something like $7,318. Now, $7,000 is nothing to sneeze at, but taking everything into consideration, I’m comfortable ‘losing’ that money for the life we’ve built in this house.
The Takeaway
Every situation is different. In our case, we were currently renting, and needed to move to another city for work. We already knew the city/housing market well (because we already owned a house there). It’s worth pointing out that although we maybe, kinda sorta ‘missed out’ on $7,318…we’ve had our own house to live in for the last 4+ years. We didn’t have to worry about the rent going up every year, we love where we live, and the house has actually appreciated roughly $25,000. Let’s say it’s more or less break-even financially and a net gain emotionally.
My point is not to convince you one way or the other whether you should take a 401k loan for a down payment on a house. It’s more about giving you the hidden details so you can make the best-informed decision for yourself. Also: don’t take buying a house lightly…it’s not as easy to profit as some people would like to believe.
Update: It’s Finally Paid Off!
After 5 years of sinking $895/mo into this thing, it is finally done! The debt avalanche has its first victim, and that $895 can go towards my car. All in all I still think it was the best solution for us at the time, but I will not miss this payment one bit!
Do you think this 401k loan was a good idea? Would you have done it?