In one of our recent real-estate investing classes, someone asked us a question that had us a little stumped, so we did some research and have found the answer. He asked us if it would ever be a good decision to borrow against a 401k account.
It turns out that it might be a pretty good idea given the right circumstances.
What you need to know
The first thing that you need to know is that when you borrow against your 401k, it is not considered a loan. You still have to pay interest, but you are paying it to yourself, so in some instances, you may end up with more than you started with.
You can borrow for up to 5 years, but, outside of that, it is pretty flexible in terms of the timeframe that you have to pay it back. As long as you pay it off in that 5-year term, you’re golden.
When borrowing from a 401k account, you can borrow up to 50% of the funds you have invested up to a maximum of $50,000. There is one exception to this. Under the CARES Act, you can borrow up to $100,000 with a longer payback period, if you are borrowing for your primary residence. The IRS didn’t give an exact specification on how much longer the payback period is, but the intent is to offer more flexibility.
Pros and cons
One of the biggest reasons that you may want to borrow against your 401k account is that it is really convenient and quick to do so. Because it is not considered a loan, you don’t have to go to a lender and you don’t have to get prequalified. It is a much easier process than getting a loan.
Another major reason to borrow this way is that it does not affect your credit score because it is not considered a loan.
Because your 401k is supplied through your job, if you were to lose that job while you are borrowing against your 401k, you will either have to pay it off in full or pay a 10% tax for violating the terms of your 401k. This is a major downside that needs to be considered when thinking about borrowing this way.
The Application
Because you are essentially taking money out of your 401k account, any investments in the 401k will not grow while that money is not in there. To me, this means that the best reason to borrow this way would be to get the money for a flip because that will bring in more money than just letting the stocks grow. This is also a very short-term investment which means that you will easily be able to pay the money back within the 5-year term.
For example, if you were to borrow the full $50,000 to flip a house and you’re expecting to see $25,000, that’s a 50% cash-on-cash return. If you complete everything within 3 months, you could see a 200% cash-on-cash return.
Borrowing from your 401k may not be super wise if you are wanting to pull it out for a downpayment on a house, because then you are losing your investments and the money is no longer growing. Of course, if the option is to borrow from your 401k and get a house or to not borrow from your 401k and not get a house, borrowing is a legitimate option, it’s just not ideal.
Recap
In summary, borrowing from your 401k can be an extremely favorable option given the right circumstances. If you are looking for something short-term, quick, and easy then borrowing this way can be a great decision, especially if what you’re investing the money into will earn you money.
