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Should I borrow against my 401k for a first time home loan? Currently living in Southern CA and thinking about an?

investment property in Palm Springs as I can't afford a home in my current market (work in Santa Monica). I don't want to over-extend myself so sharing my financial picture below. I have 94k in my 401k (can currently borrow roughly $45k), only $5,000 in savings and $5,000 in a ROTH IRA. I'm 36 and earn just above 6 figures. My current rent is $1500 which I would also need to factor in for the mortgage. I'm browsing desert properties around $300k and would use as a rental vs primary residence. Lastly, I am also considering purchasing WITH my significant other (he's an attorney and would clearly outline the terms should we split - hope that wouldn't be the case! :) which would make the payments and down payment much more manageable. Thoughts?

Jun 11, 2014 by Tina from Santa Monica, CA in  |  Flag
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Tina, If I am understanding myself correctly, you are wanting to buy a rental /investment property, not a primary residence. Based on what I see, your biggest financial problem right now isn't that you don't own enough investments, it is that you do not have any emergency savings. You are making six figures, you only pay $1500/month in rent, and yet you have not been able to save any money? Where does it all go? By now you should easily have been able to save enough to come up with a downpayment on a $300,000 property. So I wonder, if you can't save money with a $1500 rent, how will you be able to survive with a mortgage on top of that?

On the other hand, it is great that you are saving in your 401k. So should you raid that to buy a home? I would say no. This is the only place you have to go right now in the event of a serious emergency (loss of job, medical, etc.). There are a host of other reasons for NOT borrowing against a 401k, including the risk that you will be forced to repay if you leave the job (or are terminated), and just the general concept that retirement funds should be somewhat sacred. Further, if this is for an INVESTMENT property - why do you think it will do better than the various investment options in the 401k? (don't tell a survivor of two housing market crashes that real estate always goes up!) Not to mention you are taking tax deferred money and moving it to a taxable investment - that doesn't make sense either!

So my recommendation is - find out where all your money is going, cut out the unnecessary expenses, and start building up some liquid assets and save a downpayment the old fashioned way.

2 Comments   |  Flag   |  Jun 11, 2014 from Bridgewater, NJ
James D. Kinney, CFP®

Generally speaking, it is rare I would recommend borrowing from a 401k except in dire emergency when there is no place left to turn. It impedes the compound growth of your retirement funds, and in the even you are terminated or leave work before the loan is repaid, it will have to be repaid out of your remaining balance, which then becomes an early distribution subject to income tax and penalties from the IRS. Retirement funds are for retirement, they should be invested for that long term purpose and left alone to grow with regular additions from payroll.

Flag |  Jun 12, 2014 near Bridgewater, NJ
Colin

As a CPA (but not a licensed financial planner) I have to agree with everything James said. You could borrow tax & penalty free up to $10,000 for first time homebuyers from your IRA but it sounds like you plan to use this as an investment property to rent out which would probably mean you wouldn't get that $10k as a qualified distribution. It really sounds like a bad idea all around. You're borrowing against your future retirement funds for a shaky business venture...all while juggling a rent payment and abysmal savings. If you make 6 figures, you should have alot more in emergency savings...where is your $ going? I don't make 6 figures, am 33 and have about 400k in retirement savings and $30k in emergency savings. You should look to building up your emergency reserves and save for a house (for living in, not as an investment) the old fashioned way rather than raiding the piggy bank (which will be a costly proposition).

Flag |  Jun 12, 2014 near Oak Creek, WI

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1 Priority - Emergency Fund = 1/4 of your annual income

2 Priority - Risk Management, make sure you have protection in place for those extraordinary circumstances like disability, life insurance, healthcare coverage, homeowners, car insurance, etc.

3 Priority - Consult with an advisor and figure out how much you need to be saving now to retire when and how you'd like to.

After these three areas are taken care of, create your budget to figure out where the money is leaking out and reallocate it to an account earmarked for a down payment on a new home.

Make sure your thought process always remains "Save 1st, Spend what's left". If you do this you'll be part of the 4% that is financially stable and ready for growth.

The difference is simply discipline. If your priorities are in line as noted above then you'll never have a need to dip into your retirement savings. Assign a "job" for each dollar you make.

Once you have the down payment and a budget set with the new home make sure you pick the next short-term savings goal to reward yourself and keep you motivated in saving. New car? boat? vacation? It's a great feeling getting to do the fun things in life with the knowledge that you aren't giving up anything important in order to do so.

Comment   |  Flag   |  Jun 13, 2014 from Indianapolis, IN

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Don't do it Tina.... I know you want to, but don't do it....

Comment   |  Flag   |  Jun 16, 2014 from North Haven, CT

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This is a really bad idea for the reasons others have given. Let me add another reason: real estate is not a liquid investment and you have very little in emergency money. If it does not rent immediately, or the renters fail to pay on time, you could be in a severe cash crunch. I have some experience owning investment property and based on that experience would never suggest to any one that they jump into rental real estate by buying a property out-of-town.

Comment   |  Flag   |  Jun 17, 2014 from Suffolk, VA

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Tina, I have had a few clients do what you are thinking about doing over the years and it has never worked out as they expected. Borrowing from your 401k should be an "emergency only" action. Unfortunately, once money goes into a 401k, you lose a great deal of liquidity and thus, the ability to do something like what you are suggesting.

Another reason I would strongly caution you against taking a 401k loan is that, should you leave your employment, the loan would become due and payable. Not paying it back would result in a distribution, potentially subjecting you to taxes and penalties.

As others have mentioned here, consider working with a financial professional to create a comprehensive financial plan that will align all of your goals and help you to structure your savings and investments in such a way as to facilitate your overall financial goals.

View all 5 Comments   |  Flag   |  Jun 27, 2014 from La Verne, CA
James D. Kinney, CFP®

Not saying it makes sense, just saying those are the rules!

Flag |  Jul 14, 2014 near Bridgewater, NJ
Richard Charles Eddy

If you leave your employer's service (whether voluntarily or not) and still have an outstanding balance on a plan loan, you'll be required to repay the loan in full within 60 days. Otherwise, the outstanding balance will be treated as a taxable distribution, and you'll owe a 10 percent penalty tax in addition to regular income taxes if you're under age 59½.

So yes, you are in effect "borrowing your own money", but remember, you sheltered that money from taxation when you made your 401(k) contributions. So when you take the loan, you don't create a taxable event because loans are considered taxable income, but when the loan becomes due and payable and you don't pay it back (into the 401(k) plan) that loan you took (the unpaid portion) becomes a distribution, and distributions from our 401(k) are fully taxable. On top of that, if your distribution happens before you reach 59½ years old, you will owe the IRS a penalty as well.

I hope that helps. Let me know if you need more details.

Flag |  Jul 14, 2014 near La Verne, CA

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