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What market conditions would tip the scales for you to make borrowing from your own 401k a 'good' idea? The self-loan would help to increase the down payment and reduce PMI. Financially there is a lot at play: cost of PMI without the larger down payment; the 'double-tax' condition on the 401k loan; currently low mortgage interest rates; a recovering equities market and potential lost gains by removing the money from the equities market for 3-5 years; the current strong housing market; etc.

I am leaning toward taking the loan for the following reasons:

  • Current low interest rates on mortgages.
  • Interest from 401k loan (current @ 5.25%) is paid back to myself, compared with PMI payments that go to some insurance company.
  • Strong housing market may more than make up for any missed opportunities in the equities market.

Looking forward to your thoughts. Thanks.

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  • 2
    A few clarifying questions for your situation - (1) I assume you don't yet own property, and currently rent? [Keep in mind that the decision to rent vs buy is its own calculation, before deciding how to finance it] (2) Could you buy a house without dipping into your 401k? (3) Could you buy the house you want without dipping into your 401k? Nov 17 '20 at 18:38
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    You can get rid of PMI by waiting two years and then asking your mortgage company to appraise your house to confirm you have 80% equity. You can also get rid of PMI in a few months by buying a fixer, fixing it up, have the market go up during those few months, and getting a new mortgage (refi). If you bought a good deal, fixed it up, and the market went up, then you got lucky and now have 80% equity when you refi. Most people do not keep their original mortgage for 30 years. Nov 18 '20 at 17:27
  • @JuliusSeizure, your point about factoring in that PMI does not need to live for the life of the loan is a good one. But all mortgages are not created equal; some loans can have an upfront PMI cost or a minimum term (5 years for example) that the PMI is required. Read the fine print and ask questions.
    – spuck
    Nov 18 '20 at 18:18
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The risk in taking a large 401K loan comes from the speed of what one must repay the loan if one changes jobs. This can happen by choice, or not, and the risk has been substantially lessened with the new tax laws enacted by President Trump. One used to have 60 days to repay a loan, and it has now been extended until the tax day of the next year.

However, new tax laws can change and President elect Biden has stated that he would like to repeal Trump's whole tax law. Will this extend to 401K loans? Maybe, maybe not. If the law changes back to the way it used to be, you could take a loan today, lose your job sometime next year, and be forced to repay the loan in full in 60 days.

Given that most American change jobs rapidly this is a real risk and the business case starts to fall apart once you consider that you will be taxed on the outstanding loan balance as income and be assessed a 10% penalty.

Also most people find it difficult to get substantial money into a 401K. Either you have a lot of disposable income but are limited by IRS rules, or you don't have enough income to put a lot in. Being forced to take a distribution can be detrimental to your retirement outcome.

Lets say you do borrow money to buy a home and lose your job and cannot repay the loan in time for a balance of $20K. It will take you over 1 year of max contributions in order to "make up" that money. In the long run many will find this very undesirable. And opt, instead, to wait to buy a home or just pay the PMI.

So there are some business cases that can be made for borrowing from a 401K, however one must consider the risk of being forced to take a distribution. Once that is properly factored in, a lot of those business cases fall apart.

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  • "the new tax laws" Which one(s) are we talking about specifically?
    – Mast
    Nov 18 '20 at 9:55
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    @Mast part of the Trump tax plan was to change the 401K loan payback from 60 days to your tax day of the following year. Biden has expressed that he will repeal the whole tax plan even though experts see that part as consumer friendly.
    – Pete B.
    Nov 18 '20 at 11:43
  • I want to add one thing - there are some 401ks out there that do not require you to pay back the loan RIGHT away. You can be put on a payment plan (monthly) where you pay back each month - sort of like a car / house payment. This happened to me and it wasn't that bad...I had unfortunately taken a loan (I say unfortunately because for me it wasn't worth it I was young and stupid - would I take one now? Never). I was given the option to either pay it all off at once, or monthly at around 5-600 bucks each month until it was paid off. This was through fidelity and my employer.
    – JonH
    Nov 18 '20 at 19:53
  • I don't know if it would affect the answer at all, but is there a tax inefficiency angle to a 401(k) loan as well? The initial 401(k) balance is funded with pre-tax dollars, but does a borrower have to make the principal and interest payments exclusively with post-tax dollars?
    – Upper_Case
    Nov 18 '20 at 23:39
7

I recently looked into a 401(k) loan for a house purchase, though I ultimately decided against it. While I'm not a finance expert, I did consider a few things which impacted my decision and which might be useful for you:

  • If your employer allows you to contribute to your 401(k) while the loan balance is outstanding, taking the loan will be less painful.

    If your employer does not allow this, the loan can be bad twice over: you miss out on growth of money in the account, and you also miss out on the tax advantages of further contributions until the loan is paid back. It would also change your effective repayment period-- no matter how long you are technically able to take paying the loan back, the opportunity costs mount quickly the longer you take to pay the loan back.

  • If your monthly cash flow can easily handle the repayments there may be fewer downsides to taking the loan.

    Taking out the loan puts additional pressure on your monthly expenses, and even if you are confident that you can handle that pressure you may find mortgage lenders are less excited about the loan than you are. Depending on your specific situation, this could make you less attractive to mortgage lenders.

  • If you've been a good saver, the impact of the loan may not be as severe.

    If you haven't been maxing out your contributions to retirement accounts (both the 401(k) variety and an IRA), then you have missed opportunities to save money in tax-efficient ways. That's really common, but because there are annual limits to how much you can contribute to such accounts you cannot make up contributions you didn't make. Conversely, if you have been maximizing your contributions to those accounts (and, more specifically, if you've been on track or ahead of your long-term savings goals) then the disruption may not be such a big deal.

  • If the amount of money you need is relatively small (especially relative to your monthly disposable income), the risks and opportunity costs may be smaller.

    There is a big difference between a loan that will take you five years to pay back at the earliest versus one that you can repay within six months. One of the biggest dangers of a 401(k) loan is that you'll be forced to repay it in a hurry or take the loan as a distribution. The former is hard because cash isn't so easy to come up with in a short time frame (that's the very situation that makes the loan attractive!), and the latter involves losing money to taxes.

5
  • Dividends, interest and capital appreciation via investments are "free money", given to you by someone else (or the Market Gods).
  • But the interest "gained" via paying yourself back is your money. Thus, you aren't gaining anything.

IOW, if you have enough cash flow to pay the mortgage AND the 401(k) loan, then you could be using that money to grow your nest egg faster.

Thus, it's not a wise idea.

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    Regarding bullet point #2, you are gaining by not having to pay someone else interest on that portion of the loan. Which would be far more important at a time when mortgage interest rates weren't at historic lows.
    – Ben Voigt
    Nov 18 '20 at 18:32
  • @BenVoigt that ignores the next paragraph: you've got to have the cash flow to pay yourself back. What you're effectively doing is increasing your savings rate by some fraction, and then putting it into a 0% savings account. What have "you" been doing with that money this whole time?
    – RonJohn
    Nov 18 '20 at 18:40
  • It's the same cash flow you would need to pay the larger mortgage. You aren't increasing your savings fraction at all. You are trading market return for guaranteed return equal to the mortgage interest rate (plus incidental returns like dropping PMI early, losing the closing costs on the 401k loan, and transferring the "interest" on the 401k loan into the 401k). I agree that losing market return is probably a very bad idea considering how low mortgage rates are now... but in the current political climate it's not impossible that we see market rates stay much lower than historic averages.
    – Ben Voigt
    Nov 18 '20 at 19:02
  • @BenVoigt "It's the same cash flow you would need to pay the larger mortgage." Is it? A $10K loan at 5.2% for 5 years is $190/mo, and a 30 year $250K mortgage at 3.92% is $1,229/mo. The monthly rate on a $260K mortgage is only $47 higher. You could invest that extra $190-$47=$143. (The Intarweb says that 401k house loans can be longer than 5 years, but don't say how much longer.)
    – RonJohn
    Nov 18 '20 at 19:28

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