I will be closing on my first house on December 4th, and I will be bringing a 20% down payment to my closing date.
As someone who just paid off my student loans a few months ago, I definitely didn’t just have $40k lying around.
What I did have was a fairly substantial amount of money in my 401k. The only problem is an early withdrawal from a 401k means I’d be hit with taxes and penalties. If only there was a way to access the money without paying taxes or penalties…
A 401k Loan Gives You Access to Your Money
Many companies allow employees to take a loan against the money in their 401k. Note that I said MANY; companies are not required to offer 401k loans and you have to check with your HR office.
If your company does allow a 401k loan, they may let you borrow up to 50% of your vested balance.
The bad news is you will probably have to pay a fee for the loan to be processed (mine was $50) and you will have to pay back the loan with interest (my rate is 4.25%).
The good news is the loan processing fee can be pretty small (I paid $50 on a $15,000 loan, or 0.33%) and the interest you pay goes directly into your 401k account. You are paying interest to yourself!
You can take a 401k loan for any reason but it will have to be paid back within five years. The only exception is if you are using the loan to buy a house, in which case it can be longer (mine is 20 years). I just had to fax them my signed home purchase agreement and they cut a check the very next day.
The Downsides of Taking a 401k Loan
Aside from the minimal fees and interest you pay when you take out a 401k loan, there are two serious issues to consider before deciding to take a 401k loan.
The first negative is the opportunity cost of the loan. If you take out a $15,000 401k loan then you have $15k less in your investments. If your investments go up 10% over the year then your net loss will be 10% minus the interest you are paying on the loan.
There is another side to that coin. If you take out a loan and the stock market drops 10% the you will actually come out 10% better than you would have been if you left it in there.
The other danger of a 401k loan is if you leave your company. If you quit your job then the loan will be due in full in the next 60 days. Whatever you don’t pay back in that time will be counted as an unqualified distribution, which means you’ll pay taxes and a 10% penalty for all the money you borrowed.
If you are thinking about leaving your company in the near future then a 401k loan is a horrible idea.
The Best Thing About My 401k Loan
Personal finance bloggers and even certified financial planners will always talk about diversifying your portfolio. They typically mean having a mixture of different stocks and bonds. US vs. International. Large, Mid, and Small Cap. Dividend vs. Growth. Etc.
However, you aren’t truly diversified if your net worth is 100% in stocks and bonds. Other ways to diversify your net worth include precious metals (like junk silver) and of course real estate.
Before buying this house I was about 93% invested in a combination of the stock market, the bond market, and cash. My other 7% was my junk silver.
Now I’m about 66% in real estate (my house), 29% stocks, bonds, and cash, and 7% precious metals. That’s a much better diversification in my opinion.
As time goes on I will pay back my 401k loan and build up my investments again so my house isn’t such a massive portion of my net worth, but I feel so much more financially secure knowing that I have a house.
Call me crazy, but it scares the crap out of me having almost 100% of my money in the stock market. I like the idea of putting my money into things I can physically touch and/or live inside.
Putting 20% Down Saves Money
Another reason I took the 401k loan was because I wanted to have a 20% down payment. Buying a home is much more expensive if you don’t have 20% down.
- Without 20% down, you’ll need either PMI (which can be well over $100 a month) or a second loan (which will be a much higher rate than the first mortgage).
- The more money you put down the better your interest rate will be, meaning you have a lower monthly payment.
A 401k Loan Might Be Right for You
To summarize, a 401k loan lets you get to the money in your 401k without paying early withdrawal taxes or penalties. There are some fees involved and you risk removing your money from the market when it might go up.
On the other hand, it allows you to diversify your assets into a real estate purchase that is not only a valuable piece of property, but also somewhere you can live.
Readers: Have you ever taken a 401k loan? If so what did you use it for?