As real estate prices continue to rise, many investors are eager to get into the market but lack the funds for a down payment. This has led some to consider borrowing from their 401k retirement accounts to cover those costs. While using a 401k loan for an investment property down payment can help investors get started, there are some important factors to weigh. In this article, we will explore the basics of 401k loans, look at the pros and cons of using them for real estate investing, and provide tips for minimizing the risks.
401k loans allow you to borrow your own retirement savings
A 401k loan essentially allows you to borrow against your own retirement savings. Rather than taking an early withdrawal and paying taxes/penalties, a loan lets you access those funds temporarily while paying interest back into your account. Typical 401k loans allow you to borrow up to 50% of your vested account balance, up to $50,000. The funds are usually paid back over 1-5 years through automatic payroll deductions.
Using 401k funds can help cover real estate down payments
For investors who lack the cash on hand, 401k loans present an appealing way to pull together a down payment for an investment property. By borrowing $50,000 from a 401k, an investor could make a 20% down payment on a $250,000 rental property. This allows them to get started in real estate investing despite having limited funds saved outside their retirement.
Loans avoid taxes but reduce retirement savings
Unlike 401k early withdrawals, loans allow you to access those funds without paying income taxes or early withdrawal penalties. However, the loan balance is removed from your account, so it will no longer benefit from continued tax-deferred growth. Depending on market performance during the loan term, you may miss out on significant investment gains.
Use extra caution if borrowing more than 50% of your assets
Some 401k plans may allow you to borrow more than 50% of your balance, but this significantly increases the risk. If you lose your job, the loan usually must be repaid in full within 60-90 days to avoid taxes and penalties. With over half your assets tied up in real estate, you may be forced to take a loss and sell at an inopportune time.
While 401k loans can provide capital for real estate investments, contributing to retirement savings should take priority. Limit loan amounts to less than 50% of your balance, have a backup plan for repayment, and aim to replenish your retirement savings as quickly as possible after funding your down payment.