When is it 'ok' to borrow from a 401k to purchase a house?

The risk in taking a large 401K loan comes from the speed of what one must repay the loan if one changes jobs. This can happen by choice, or not, and the risk has been substantially lessened with the new tax laws enacted by President Trump. One used to have 60 days to repay a loan, and it has now been extended until the tax day of the next year.

However, new tax laws can change and President elect Biden has stated that he would like to repeal Trump's whole tax law. Will this extend to 401K loans? Maybe, maybe not. If the law changes back to the way it used to be, you could take a loan today, lose your job sometime next year, and be forced to repay the loan in full in 60 days.

Given that most American change jobs rapidly this is a real risk and the business case starts to fall apart once you consider that you will be taxed on the outstanding loan balance as income and be assessed a 10% penalty.

Also most people find it difficult to get substantial money into a 401K. Either you have a lot of disposable income but are limited by IRS rules, or you don't have enough income to put a lot in. Being forced to take a distribution can be detrimental to your retirement outcome.

Lets say you do borrow money to buy a home and lose your job and cannot repay the loan in time for a balance of $20K. It will take you over 1 year of max contributions in order to "make up" that money. In the long run many will find this very undesirable. And opt, instead, to wait to buy a home or just pay the PMI.

So there are some business cases that can be made for borrowing from a 401K, however one must consider the risk of being forced to take a distribution. Once that is properly factored in, a lot of those business cases fall apart.

I recently looked into a 401(k) loan for a house purchase, though I ultimately decided against it. While I'm not a finance expert, I did consider a few things which impacted my decision and which might be useful for you:

• If your employer allows you to contribute to your 401(k) while the loan balance is outstanding, taking the loan will be less painful.

  If your employer does not allow this, the loan can be bad twice over: you miss out on growth of money in the account, and you also miss out on the tax advantages of further contributions until the loan is paid back. It would also change your effective repayment period-- no matter how long you are technically able to take paying the loan back, the opportunity costs mount quickly the longer you take to pay the loan back.

• If your monthly cash flow can easily handle the repayments there may be fewer downsides to taking the loan.

  Taking out the loan puts additional pressure on your monthly expenses, and even if you are confident that you can handle that pressure you may find mortgage lenders are less excited about the loan than you are. Depending on your specific situation, this could make you less attractive to mortgage lenders.

• If you've been a good saver, the impact of the loan may not be as severe.

  If you haven't been maxing out your contributions to retirement accounts (both the 401(k) variety and an IRA), then you have missed opportunities to save money in tax-efficient ways. That's really common, but because there are annual limits to how much you can contribute to such accounts you cannot make up contributions you didn't make. Conversely, if you have been maximizing your contributions to those accounts (and, more specifically, if you've been on track or ahead of your long-term savings goals) then the disruption may not be such a big deal.

• If the amount of money you need is relatively small (especially relative to your monthly disposable income), the risks and opportunity costs may be smaller.

  There is a big difference between a loan that will take you five years to pay back at the earliest versus one that you can repay within six months. One of the biggest dangers of a 401(k) loan is that you'll be forced to repay it in a hurry or take the loan as a distribution. The former is hard because cash isn't so easy to come up with in a short time frame (that's the very situation that makes the loan attractive!), and the latter involves losing money to taxes.

• Dividends, interest and capital appreciation via investments are "free money", given to you by someone else (or the Market Gods).
• But the interest "gained" via paying yourself back is your money. Thus, you aren't gaining anything.

IOW, if you have enough cash flow to pay the mortgage AND the 401(k) loan, then you could be using that money to grow your nest egg faster.

Thus, it's not a wise idea.