Working for the Federal government, our 401k is called the Thrift Savings Plan (TSP). We max out our contributions each year. As a means of bridging down payment gaps, we utilized a little-known option – the TSP loan.
Per TSP.gov, “When you take a loan, you borrow from your contributions to your TSP account. Your loan amount can’t exceed the amount of your own contributions and earnings from those contributions. Also, you cannot borrow from contributions or earnings you get from your agency or service.” There are two loan options: general purpose and real estate. There are different requirements to meet for each type of loan.
First, here are some items to consider in the decision-making. While these rules pertain specifically to the 401k program provided to Federal employees, TSP, your employer’s 401k service provider should have a similar program for taking a loan from your account and rules associated with paying that loan back.
- You have to begin making loan payments immediately after your draw down. A general purpose loan must be repaid within 5 years, and a primary residence real estate loan must be repaid within 30 years but you have control over the amount of each payment, as long as the amortization keeps the repayment within the required period.
- You pay interest on the loan, which is set at the ‘G Fund’ rate. According to the TSP website, the interest rate is 0.875% as of 1/17/2021. This interest payment is paid into your TSP account.
- There is a loan fee of $50.
- You must be currently employed by the government to take the loan, since repayment is processed through payroll deductions, and if separating from the government you must repay the loan in full within 60 days of separation.
The common talking point working against using a 401k loan is that you need to weigh the loss of compound growth on the balance of your TSP against what the loan will gain you. Many financial talking heads will warn you of using your retirement account for immediate, frivolous purchases. But, used appropriately and strategically, Mr. and Mrs. ODA fully believe that 401k loans can open up financial doors much earlier than through more “traditional” means.
Our first loan was for our primary residence. While Mr. ODA was an excellent saver through college, he expected to buy a house for about half the cost of what a very basic house goes for in Northern Virginia. Our opportunity cost was private mortgage insurance (PMI); did we want to pay PMI (an added cost that a bank adds to your monthly loan payment to mitigate the risk if you don’t bring a 20% down payment to the house purchase) or take out TSP loans to make up the difference for our down payment? Taking out a loan was ‘out of the box’ and seemed controversial. However, paying PMI indefinitely and being subject to the bank’s decision on when PMI could be removed was more concerning. PMI is building the bank’s “pockets,” while the interest on a TSP loan is going back to your TSP account.
We decided to each take a residential loan from our accounts. I took a $15,000 loan and Mr. ODA took a $25,000 loan. By taking a TSP loan, we were losing out on the earnings of the accrued balance, but the repayment to ourselves of the G-fund rate was a reasonable trade off. Plus, we could put any extra money towards the loan at any time, thereby increasing our TSP balances faster.
My loan draw was 7/2/2012, and I had it paid off by 3/17/2015. We could have stretched the payment over the full 30 years to fully leverage our money, but at the time, owning rental properties wasn’t on our immediate radar. However, two incentives to pay a TSP loan off faster than a allowed amortization are 1) that you can only have one loan of each kind at a time, and 2) you can’t request a new loan within 60 days after you paid off a TSP loan. Then there’s that opportunity cost; we wanted to get our money back into our tax incentivized account as quickly as possible to get it working for us again.
Since our experience was positive for these two loans, we kept this option on the table for future transactions. In 2016 and 2017, we purchased 9 rental properties using regular savings from our high savings rate lifestyle and the equity we were able to cash in from the sale of our first primary home. To cover the down payment of the last few purchases, Mr. ODA and I each took a general purpose loan of $50,000, which is the maximum amount for such type of loan. The loan rate at that time was 2.25%, which was a great lending rate back in 2017. We paid my loan off first, fairly aggressively using the cash flow from the rental properties we purchased, knowing that since I would be separating from the government once we had kids it had to be paid sooner than later. Mr. ODA has adjusted the repayment amount per pay check several times since 2017 to meet our cash flow needs. The loan was issued on 9/1/2017 and currently has a balance of $12,370.
When looking at the opportunity cost comparison for the rental property purchases, we determined that the 4 ways we make money in real estate investing outweighed the likely (and what actually turned out to be very lucrative) gains of the stock market.
- Cash Flow – Profit from rent after all expenses are paid.
- Principal Pay Down – The amount the tenant essentially pays out of your mortgage payment that goes directly to the equity of the house.
- Appreciation – The increasing of property value based on the market.
- Tax Advantages – Being able to utilize the tax code in an advantageous fashion as a business owner.
By carefully evaluating each property to ensure we had near-guarantees of all 4 of these methods working, we thought that the benefits of owning more rentals outweighed the loss of share ownership in our TSP accounts.