Is a 401k home loan a good idea?

[uofmbish]

Hello,
I’ve been a long time lurker and would appreciate your opinions on an option I have been playing around with regarding my first home purchase. Sorry for the long post.

I had always heard that taking a loan from your 401k for a home purchase was a horrible idea, so I didn’t give it much weight until I got my first estimate for PMI charges. Now that I am looking into it, I can’t seem to find the “catch”.

Here is a bit of background on my situation. My wife and I are looking at homes in the 350k range in a high cost of living area. We make about 150k per year combined and have saved about 50k for a downpayment.

Our first estimate from a mortgage broker was for an FHA loan, which has a 1.5% up front charge if PMI is required. That works out to roughly 5k up front plus 3k per year in PMI charges. Assuming that we pay PMI for five years, that would be about 20k total in PMI payments.

On the other hand, if I were to withdraw ~20k from my 401k in order to get to a 20% downpayment, I would avoid these charges and essentially earn a guaranteed 100% return on the funds over 5 years.

The biggest complaints that I have seen regarding 401k loans is that people tend to defer new contributions while they repay the loan, which ultimately results in a lower account balance. My wife and I already max out our contributions, so this actually seems like a benefit to me. I can put in more contributions (the interest on the loan) then would otherwise be allowed.

The other concern is that if I were terminated, the funds would need to be repayed within a few months or it would be considered a withdrawal. This doesn’t seem like a huge deal to me as our income would decline so much in the event of my layoff, that the tax penalty consequences would seemingly be minimal. Also, the alternative burdens of getting a larger mortgage and paying PMI wouldn’t go away if I were layed off.

Before I make a potentially huge mistake, am I missing something?

Thanks!

[Animorph]

Don't blow off the lose your job scenario too quickly. There would be the early withdrawal penalty (10% I think) in addition to the taxes, presuming you're not old enough yet. All paid without a job, and the permanent $20k drop in tax-favored funds. Or pay the $20k back without a job.

Of course there are investment opportunities lost with $20k out of the 401k, but with your estimated savings that all may be worth it.

Certainly sounds tempting.

[teejayevans]

Understand you will be paying tax twice on the interest on the loan.
Example, you take out 50K, pay back 50k+10K interest. That interest is
paid with money that has already been taxed, when you pull that 10K
out years later, you pay tax on it again.
TJ

[uofmbish]

Quote:

Originally Posted by teejayevans Understand you will be paying tax twice on the interest on the loan. Example, you take out 50K, pay back 50k+10K interest. That interest is paid with money that has already been taxed, when you pull that 10K out years later, you pay tax on it again. TJ

Sorry, I should add that this is a Roth 401k, so all of the money has already been taxed and would be withdrawn tax free at retirement.

[bbbamI]

I assume you're receiving a portion of your 401k contribution matched by your company. I don't believe you will receive the match when you're paying the loan back. Dollars lost there.

I haven't done the other calculations and maybe since I'm retired; IMO retirement accounts should not be touched until you're retired....unless there is a medical emergency.

My 2 cents.

[jdw_fire]

i have never been able to understand the downside of borrowing this way provided 1) you dont reduce your contributions and 2) you dont lose your job. and in your case you have the added advantage of saving the PMI which greatly increases your yield.

Quote:

Originally Posted by teejayevans Understand you will be paying tax twice on the interest on the loan. Example, you take out 50K, pay back 50k+10K interest. That interest is paid with money that has already been taxed, when you pull that 10K out years later, you pay tax on it again. TJ

2 things: 1) as the loan is for a principle residence isnt the interest tax deductable? 2) even if it isnt, lets say the money was borrowed from some other means (besides using the house as you are trying to avoid PMI) then when you pay that back it will be with after tax dollars so the loan will cost you the same provided the interest rate is the same. on the 401k side the interest on the loan is treated as any other return on the funds inside the 401k so again it doesnt cost you any more. therefore the double taxation arguement is flawed.

Quote:

Originally Posted by bbbamI I assume you're receiving a portion of your 401k contribution matched by your company. I don't believe you will receive the match when you're paying the loan back. Dollars lost there.

why wouldnt you receive matching if you are still contributing in addition to paying back the loan?

[bbbamI]

Quote:

Originally Posted by jdw_fire why wouldnt you receive matching if you are still contributing in addition to paying back the loan?

It depends on the company plan.

My Megacorp would not handle a loan payment/extra contribution combo. The loan was set up with a particular interest rate and time period. Once the loan was repaid per the agreement, the contributions were once again matched by the co.

[Katsmeow]

Quote:

I assume you're receiving a portion of your 401k contribution matched by your company. I don't believe you will receive the match when you're paying the loan back. Dollars lost there.

This very much depends on the plan. At my husband's employer the match does not stop while you have a loan. Further, at his employer, if you leave employment the loan does not have to be repaid early (most plans do require early repayment his doesn't.

Quote:

Understand you will be paying tax twice on the interest on the loan. Example, you take out 50K, pay back 50k+10K interest. That interest is paid with money that has already been taxed, when you pull that 10K out years later, you pay tax on it again.

This is true regardless of whether it is a 401(k) loan or not.

Let's say you don't have a 401(k) and you have paid tax on $50,000 income. So the money has been taxed once.

You loan $50,000 to your friend Joe. He repays you. The interest he pays you is taxable income to you and you pay tax on it. So the money has been, under your scenario, taxed twice.

There are reasons to be hesitant with 401(k) loans, but double taxation is not one of them.

[brewer12345]

To OP, the 401k loan sounds like a no brainer under two conditions:

1) You are reasonably confident you will not lose or leave your job until the loan is repaid.

2) You have adequate emergency funds outside of retirement accounts after making the downpayment.

2 applies even if you take PMI.

[teejayevans]

Quote:

Originally Posted by jdw_fire 2 things: 1) as the loan is for a principle residence isnt the interest tax deductable? 2) even if it isnt, lets say the money was borrowed from some other means (besides using the house as you are trying to avoid PMI) then when you pay that back it will be with after tax dollars so the loan will cost you the same provided the interest rate is the same. on the 401k side the interest on the loan is treated as any other return on the funds inside the 401k so again it doesnt cost you any more. therefore the double taxation arguement is flawed.

1) the mortgage is deductible, because the 2nd loan is not using the house
as collateral (like a home equity loan), I don't think it qualifies as a deduction.
2)a regular loan costs you 10k in my example, a 401k loan costs 10k plus
say 25% in taxes so it costs 12.5k. Any other return on funds is not coming
from you, so it's not being taxed twice, actually it is but somebody else is
paying the tax the first time.
TJ

[jdw_fire]

Quote:

Originally Posted by teejayevans 2)a regular loan costs you 10k in my example, a 401k loan costs 10k plus say 25% in taxes so it costs 12.5k. Any other return on funds is not coming from you, so it's not being taxed twice, actually it is but somebody else is paying the tax the first time. TJ

i think you are incorrect in that double taxation is costing the borrower more. just stating numbers isnt showing it so how bout you lay out all the details showing that.

[Katsmeow]

A number of articles addressing the double taxation myth

401k Loan Double Taxation Myth - The Finance Buff

Better Example Against Double-Taxation Of 401(k) Loans » My Money Blog

My Financial Awareness - Myths

Planning for Aliens » Blog Archive » 401k Loan: The Double Taxation Myth

401(k) loans: Are you really taxed twice? | Vanguard Blog

401k Double Taxation | 401k Planning

[eridanus]

When you get rid of the PMI, either through rising home value or equity, you get back part of the PMI up-front charge.

I think 401k loans are worthwhile tools IF you can pay it back if you get laid off (even if you have to borrow from a brokerage margin account). It also helps to have a working spouse not at the same company or in the same field.

[teejayevans]

Quote:

Originally Posted by Katsmeow A number of articles addressing the double taxation myth 401k Loan Double Taxation Myth - The Finance Buff Better Example Against Double-Taxation Of 401(k) Loans » My Money Blog My Financial Awareness - Myths Planning for Aliens » Blog Archive » 401k Loan: The Double Taxation Myth 401(k) loans: Are you really taxed twice? | Vanguard Blog 401k Double Taxation | 401k Planning

First one completely ignores the second tax on the interest when withdrawn
during retirement and is a poorly written with completely irrelevant analogies.
Ditto the 2nd one, this is why I do my own financial planning.

I jumped to Vanguard blog which is accurate, the interest is
taxed twice, but that doesn't mean its a bad deal, since the interest is paid to
yourself, but you should understand what you are doing.
TJ

[teejayevans]

Quote:

Originally Posted by jdw_fire i think you are incorrect in that double taxation is costing the borrower more. just stating numbers isnt showing it so how bout you lay out all the details showing that.

One last time...
You take out a loan, that loan is paid back with interest.
The interest is paid back with after tax dollars (that's 1)
When you take that interest money out of the 401k at
retirement, its considered income and is taxed again (that's 2).

As I said in the other post, it still may be a good deal to take
out the 401k loan, you should understand what you are doing.
Tom

[mf15]

I did it about 9 years ago,took a loan for 25K to help my son buy a house. Had to pay the loan back in 5 years,plus you pay the interest to yourself. I also kept my contributions the same and my company matched at the time. For me I had no problems. Seems like a no brainer unless you get layed off.
Old Mike

[jdw_fire]

Quote:

Originally Posted by teejayevans Quote: Originally Posted by jdw_fire i think you are incorrect in that double taxation is costing the borrower more. just stating numbers isnt showing it so how bout you lay out all the details showing that. One last time... You take out a loan, that loan is paid back with interest. The interest is paid back with after tax dollars (that's 1) When you take that interest money out of the 401k at retirement, its considered income and is taxed again (that's 2). As I said in the other post, it still may be a good deal to take out the 401k loan, you should understand what you are doing. Tom

like i said

Quote:

Originally Posted by jdw_fire i think you are incorrect in that double taxation is costing the borrower more.

and the key statement here is "costing the borrower more". since it doesnt (and sometimes it costs less), isnt that what is important? the "double taxation" arguement is a red herring and just gets uninformed people all worried about losing money by borrowing this way.

Quote:

Originally Posted by teejayevans you should understand what you are doing. Tom

i presume when you say this you are referring to understanding that you are paying taxes twice and i would ask why is it important for people to know that since all it does (without completely running thru what is going on) is scare the person in this situation into thinking he is paying too many taxes and therefore is losing out somehow. since he isnt losing out from a tax stand point why does he need to be scared, in fact, why is it even relevant?

[uofmbish]

Thank you all for the replies!

bbbamI - Nope, no match from my employer. I do get a very generous profit sharing contribution though that would not be impacted.

eridanus - I had no idea that part of the up front PMI charge may be refunded. That definitely impacts my calcs, so I'll look into that.

teejayevans - I am fairly certain that I will only be taxed once with this being a Roth 401k. Both the contributions and eventual loan interest payments would have already been taxed and should be able to be withdrawn tax free at retirement.

[jdw_fire]

Quote:

Originally Posted by uofmbish eridanus - I had no idea that part of the up front PMI charge may be refunded. That definitely impacts my calcs, so I'll look into that.

it doesnt impact that much as this loan would make sense even if you werent saving any PMI. the PMI you save is all gravy.

Quote:

Originally Posted by uofmbish teejayevans - I am fairly certain that I will only be taxed once with this being a Roth 401k. Both the contributions and eventual loan interest payments would have already been taxed and should be able to be withdrawn tax free at retirement.

this doesnt matter, when you borrow money unless it is a mortgage on a primary residence, the money you use to pay it back is taxed. and when you loan out money you pay taxes on the interest unless you loan it out of a roth. the only reason it can be called double taxed is cus you are both the lender and the borrower. the double taxation argument is bogus.