Ask most financial planners and they will strongly advise against borrowing from your 401K to buy a second home. Borrowing from your 401K to purchase a vacation home or rental property exposes you to more financial risk. However, are there situations where taking a loan from your 401K to make a down payment makes sense?
Suppose you’ve found a great deal on the perfect vacation home or rental property (check out my rental property investment program). You’ve got some equity built up in your current house, you have a decent amount of money set aside in an emergency fund and your retirement accounts are well funded considering your age. You know you can afford the monthly payments but you’re trying to decide the best way to finance the property.
Let’s look at the most common Second Home financing options:
Cash: A surprising number of second homes are purchased with cash. Many folks argue that tying up that much equity in a vacation home or investment property is foolish, but buying with cash(if you can afford) is the best way to minimize your financial risk.
New Mortgage: Another popular financing option for purchasing a second home or investment property is to take out a new mortgage on the property. You’ll need at least 20% down to get a stand-alone mortgage on a second home (many banks require 30% or more on second home). Provided it is for your personal use, interest on a second home may be deductible from your taxable income (unless it is a rental). However, don’t buy a second home for the tax advantages. Be sure to talk to a CPA about the tax consequences of buying a second home (regardless of which financing method you use).
Home Equity: If you have enough equity built up in your home, you may consider home equity loan or cash-out refinancing. Let’s say you owe $100,000 on your home and its fair market value is around $300,000. You refinance your home for up to $240,000 (keeping 20% equity to avoid PMI insurance) and pocket $140,000 that you could use to purchase the vacation home or investment property.
401K Loan: Another popular second home financing option is a 401K loan. Most 401K loans have a provision that allow people to withdraw up to half of their 401k balance or $50,000 (whichever is less). While $50,000 probably isn’t enough to buy that vacation home or rental property you’re looking at, it may be enough to meet the 20%-30% down payment that is usually required by banks to get a mortgage. There are many things to consider, though, when looking at a 401K loan:
Advantages of a 401K Loan to Buy Second Home:
- Instant access to cash.
- You pay the loan back to yourself.
- You pay interest back to yourself.
- A way of leveraging 401K balance into real estate you can use.
- Can help “diversify” your retirement portfolio.
Disadvantages of a 401K Loan to Buy Second Home:
- If you leave your employer you need to pay it back within 60 days (or incur penalties).
- Payments are high given the maximum term of only 5 years.
- If the market goes up, you’ll miss out on the appreciation.
Depending on your financial situation, it may not be a horrible idea to borrow money from your 401K as a down payment on a second home or vacation property. It’s a way of diversifying your retirement portfolio by investing in an asset that you can actually use (or rent out).
The more money you have in your 401K, the less risky a 401K loans becomes. If you have $800,000 in a 401K, borrowing $50,000 isn’t going to be as a big deal as it would be if you had $100,000 in your account.
The most important thing is to look at your overall cash-flow situation and make sure you have enough income to comfortably cover the various 401K loan and mortgage payments associated with your second home (let alone your first home and other financial obligations).
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