Should I use a 401K loan as a down payment for a rental property?
Baltimore, MD · Member since 2017 · 30 posts · 6 votes
My husband and I are thinking of using a 401K loan as a down payment on our first multi-family rental property. We may or may not live in it as well. We both work full time and we'd like to use all of the cashflow to pay back the loan & then after that, save for another property. If we live in the property and the other unit covers most or all of the mortgage we can pay down the loan faster. Does that sound like a good strategy?
I think that depends on the lender and the employer. I used a 401k loan to kick start my investing and bought 2 houses at the same time (Cash deals). I used a non secured loan to fund the rehabs and did a cash out refinance to pay back the unsecured loan. I kept the rest of the cash from the refinances as a down payment and renovation fund for the next house and got a mortgage for 75% of that purchase price. The lender never took into consideration my 401k loan and I am still paying it back now. I could have used the money from the cash out refinance to pay it back but its a 4% loan and I wanted to keep the ball rolling.
I would definitely recommend using this strategy to get started as long as you are smart about the property you purchase. Make sure that it makes sense and cashflows. Good Luck
@Monica Young - You can certainly use a 401k loan to help get the ball rolling with investing. One thing to be aware of is how a lender will look at this. Since you have to repay the loan out of your paycheck, the payment amount on the 401k loan will count against you for DTI purposes. You might try to get the 401k loan after the lender calculates DTI, but they will also ask for bank statements showing you have the funds to close (usually going 1-3 months back). So you need the funds in your bank account or a good explanation of where they are coming from.
I'd highly recommend starting out with a multifamily property and living in one unit while renting out the other(s). You will be able to get more favorable financing terms and you'll also get great hands-on experience.
I think that depends on the lender and the employer. I used a 401k loan to kick start my investing and bought 2 houses at the same time (Cash deals). I used a non secured loan to fund the rehabs and did a cash out refinance to pay back the unsecured loan. I kept the rest of the cash from the refinances as a down payment and renovation fund for the next house and got a mortgage for 75% of that purchase price. The lender never took into consideration my 401k loan and I am still paying it back now. I could have used the money from the cash out refinance to pay it back but its a 4% loan and I wanted to keep the ball rolling.
I would definitely recommend using this strategy to get started as long as you are smart about the property you purchase. Make sure that it makes sense and cashflows. Good Luck
@Michael Seeker - I didn't realize we'd need to have the funds in our account to get the loan. That's for actual approval, not pre-approval right? We haven't done that yet either. The only reason living in the property is a maybe is because we're looking in the Baltimore County area of Maryland and multi-family properties are hard to come by... at least in any areas we want to live in. We're working with a new agent who's an investor himself with several rental properties of his own so hopefully, we'll have better luck finding something now.
Just make sure you don't get stuck in a situation where you have to pay the 10% penalty and tax on top of that if you were to lose your job. I use my 401K loan as a fall back plan in case I need a quick loan and not as a primary investment fund source. Realize your paychecks will be smaller, your money is not earning anything in the market while it's loaned to you, and perhaps the worst thing is that if you take a loan, you don't have the safety net of using your 401k for a loan until that one is paid (in many cases).
@Nathan Waters - That's a really interesting strategy. I guess I'll just have to see what the lender does. I'm sure I can come up with something. Thanks.
@Matt Mayotte - Good point. We have the flexibility in our budget to handle a smaller paycheck for a while. Not ideal, but it's doable. Also, we wouldn't be taking out the max amount we can take at this time so there will be some left if we need another loan.
@Michael Seeker - I didn't realize we'd need to have the funds in our account to get the loan. That's for actual approval, not pre-approval right? We haven't done that yet either. The only reason living in the property is a maybe is because we're looking in the Baltimore County area of Maryland and multi-family properties are hard to come by... at least in any areas we want to live in. We're working with a new agent who's an investor himself with several rental properties of his own so hopefully, we'll have better luck finding something now.
I'm assuming you'll be doing a conventional 30 year fixed interest rate loan. If you go some other route for a loan (commercial, hard money, etc) then it's possible the lender may not look as closely at your DTI or use the same formula to compute it. You might have an easier time getting a loan, but the terms will be less favorable (higher interest rate, lower amortization period, shorter term, etc).
I have been pre-approved for loans before based on information provided to the loan officer only to be turned down later after the underwriters reviewed all of my financial information. A good loan officer will do all the work on the front end and tell you whether or not you will be able to get the loan. A bad one will give you a pre-approval (which literally means nothing) and then let you find out later that you don't qualify because your DTI is 45% and 43% is the max.
For a conventional loan, the payments on a 401k loan should be counted towards your DTI. If a bank does not count it when computing your DTI, then it is an oversight on their part. I wouldn't count on a bank missing this.
Here's a link with an example of the difference between using a 401k loan vs bank loan for financing a purchase of a primary residence: https://smartasset.com/mortgage/when-to-leverage-a-401k-for-a-home-down-payment
I have the ability to take out 1 loan per year, up to 3 at a time. So going forward I am planning on taking out 1 each year for a 3 year term to purchase real estate. I know some people hate the idea of borrowing against their 401k. But a couple things to consider;
1- Account for the loan payment in your analysis. Even though you can afford the pay reduction, make sure the property cash flows even with your 401k loan payment.
2- Understand that if you leave the company for any reason, you will have to pay back the loan in full or pay some stiff penalties
3- You will significantly impact your potential 401k earnings so it needs to make sense. Obviously borrowing against the retirement to invest in real estate is better than using it for vacation. But its something to consider.
keep in mind your worst case scenario: retirement accounts are protected funds... but once the funds are removed, no.
Tyler Mullen, CFE
@John Dombrowski - Yes, that's on the pro list. We don't have much of a savings yet because we just finished paying off some credit card bills. That's where the wiggle room in our paychecks comes from. We could wait a year or so to save up money and purchase or we could get started now with a 401k loan. This way, we'll be paying ourselves back. We have a little credit card debt left, but it's manageable now with a debt usage of less than 35%.
@Michael Seeker - Yes, we plan to get a conventional loan. Interest rates are low right now. We owned a house about 7 years ago that we used a 401k loan to get & they didn't take the loan payment into account when we got that (and neither did we). It turned out to be a nightmare. Without going into too much detail, we did a short sale on that house. We don't want to make the same mistakes again so we're being a lot more cautious now that our credit and income is better than it was then. We anticipate that we will qualify for around a $600K loan, but we only plan on using $350K - $400K. Thanks for that link. I think we fall into the "good cash flow and minimal non-401(k) savings" category.
@Nathan Waters - Thanks. That is a very good bullet list to follow & those are some of the things I learned the hard way. On point number 2, that is not always the case. I had a 401k loan at an old company & they allowed me to leave it at the same company and continue to make the payments after leaving the company. I know that's rare. It was a small company & I did some consulting work with them after I left, but it is a possibility. I just had to ask for it. I'm not counting on that this time. I just wanted to throw that out there.
@Tyler Mullen - What do you mean by "protected"? Do you mean from creditors or taxes?
You're on the right track, yes. Bankruptcy for instance, retirement accounts are (usually) shielded through that process but when you take the funds out of that account then they become regular capital available to you for any purpose, which makes them subject to the same risks as regular capital.
I'm not necessarily against your idea, just wanted to make sure you have all the risks in mind so you have the chance to develop a robust fallback plan. What is your strategy timeline for paying the funds back, can you still pay the funds back even if this deal doesn't go as well as planned?
You want to make sure you have a fallback plan for the worst case scenario then arrange so if that happens you're not out of the game.
@Tyler Mullen - Preparing for the worst case scenario is precisely why I posted this question. These kinds of responses are what I'm looking for. One of the reasons we are low balling our max purchase price from what we qualify for is that we want to be able to cover everything during vacancies or any other issues. We've been overextended before and we don't want to be in that position again. The best case scenario is that we pay off the loan in 2 years by paying more than the min so that 2-year calculation is what we'll be using in our analysis, but we want to be able to cover the minimum payment at all times. Thanks. This is great information.
I actually used a 401k loan as part of the down payment on my first property. It worked quite well in terms of the actual purchase, but the specific property really couldn't support the high payments, which I should have figured out in the analysis stage.
The short 5-year term of the 401k loan led to high monthly payments which made it difficult to cashflow initially on the property. So just make sure the deal supports giving you cashflow at a comfortable positive number even including the high 401k loan payments. If I were to do a 401k loan again, it would only be in a situation where I have a short term payback, like a flip or a BRRR or a cash purchase with later bank refinancing, and not for a straight buy-and-hold.
I bought my first multi-family with this model a few months ago and I do recommend it. You pay yourself back the interest. Like you, I"m using the cash flow to repay the loan. My ROI with the loan is 11% and after the loan is paid will be over 25%. Tough to do that in the market and with market at all time highs it may be a ideal time to do it (but nobody can predict what the market will do). I can pay my loan back in full at anytime but I'm saving for another property. Good luck!
@Monica Young I know BP members are a big fan of BRRR. So you could borrow do a BRRR then when you refinance you could get your money back and pay off the loan. I remember a pod cast, @clayton Morris, not sure which number but he talks about using your 401K loan to invest. Hopes some more perspective helps.
@Monica Young speak with a CPA but my short answer would be yes :)
I did this and it worked out fine.
My lender did not consider the loan to be borrowed money. He considered it as an asset transfer from one asset type to another.
The loan payment did not count as part of my DTI. Again, it was considered an asset transfer.
I did the loan before I went under contract. That way I had proof of cash sitting in my account.
My particular plan administrator allowed me to pay extra toward the loan by sending in a check as well as the amount withheld from my paycheck, so I was able to pay it down faster. (I used my new rental income to do so... WOOT!). Not all plan administrators allow extra payments, so make sure you ask.
I did leave that employer before the loan was paid off and I did need to pay it down in full within 30 days or risk having it declared a distribution, subject to 10% penalty, etc. Luckily, I had the funds to do so, so no big deal for me. Your risk may be different.
If you are able to get a higher rate of return with your property than you can in whatever funds you're invested in with your 401k, why not?
When you pay the loan back, you're paying interest to yourself. So there's a guaranteed rate of return right there.
I looked at the loan as just another asset in my 401k that was paying a guaranteed interest income at a guaranteed rate. Much better than the bouncing around in the mutual fund market.