After hearing a co-worker talk about taking a 401(k) loan to help with the downpayment on his new house, I decided to ask the HR Department about it. Here are the rules for my company, yours may be slightly different.
You can borrow the lesser of 50% of your vested balance, or $50,000. So with my current financial status, that would be approximately $6,000. The interest rate charged is WSJ Prime + 1% at the initiation of your loan (Currently 5.5+1 = 6.5%). But the interest is paid directly back into your account. You can repay it over 20 years if the loan if for your house, and 5 years otherwise.
At first glance, this seems like a great option. You get to borrow you own money so that you can make your downpayment larger, avoid paying Private Mortage Insurance (PMI), and since you’re loaning yourself the money, the interest goes back to yourself! I didn’t know you could stretch it out for so long – 20 years?!
If you look closer, however, the situation is a significantly more complicated. The key is that you need to estimate the amount of money that you would be earning if you didn’t borrow that money. I mean, that’s why it’s there right? To compound tax-free for retirement? What you save in PMI or mortgage interest must be balanced out by the amount that you would be losing in retirement.
In addition, you will be taking out pre-tax money, but paying the interest back with post-tax money. For example, if your monthly interest payment is $250 and you’re in the 25% tax bracket. You’ll have to make $333 pre-tax to make $250 post-tax. Then, when you retire and take the money out once more, you pay taxes yet again. Doh.
This doesn’t mean you shouldn’t definitely do it. It just means you have to carefully weigh the consequences. This MSN Money article shares more information about the pros and cons. From that article, in 1998, 9% of the nation’s 401(k) participants took loans against their 401(k) plans. An plan experts say that overall, 20% of 401(k) participants are paying back loans. Be sure you aren’t “mortgaging” your future for that house. (Ok, bad joke, it’s early.)
Update: Here is another article about 401(k) loans and includes some sample calculations. Also, if you have a 401(k) loan yourself I’d love to hear your thoughts and experiences!