Back when I was growing up Mad magazine was a favorite of kids. (maybe it still is). They had many regular features, but the best known was a character named Alfred E. Neuman. He wandered through life ignoring danger. And he introduced a whole generation of kids to the phrase "What, Me worry?"
Fast forward to 2008. I recently received the following email:
I am trying to help my nephew, who wants to buy his first house at the age of 51. He wants a $300,000 house, mortgaged for 20 years. But he and his wife declared bankruptcy (credit card debt) a few years ago, and though he is at the end of paying off his debit, he finds it hard to get a good mortgage deal. His best bet, I think, is to pay at least 20% down. But he has only $29,000 (an interest-free loan from me). Shouldn't he borrow from his 401K the rest of the 20% needed (they do have $31,000 in their 401K accounts)? Suppose he saves one-half a percent? Would that be worth it? (I do not know the details of the 401Ks, but let us assume some "typical" case.)
Edward was responding to an article I had written about how to evaluate 401k loans. Let me first compliment him on his generosity and willingness to help his nephew. But, if we step back and look at the situation we might find Mr. Neuman's handiwork.
Let's begin with the facts that Edward includes in his email. His nephew is 51 and got in enough credit card debt to declare bankruptcy. We don't know whether it was a job loss or medical issue that caused the credit card debt. But, it could be possible that Nephew is a little too quick to pull out the plastic when he sees something he wants. Edward needs to make sure that's not the case. If that is what caused the problem Nephew will probably not be able to keep the house even with his uncle's help. Sooner or later the credit card bills will begin to conflict with the mortgage. And some of the bills just won't get paid.
Ed is right. Finding a good deal on a mortgage will be hard. That's because lenders know that people who have had debt problems before are more likely than average to have them again. And, yes, a larger down payment will tend to keep the interest rate down But, look at where that down payment comes from. $29,000 comes from an interest free loan from Uncle Ed. (for the record, most mortgage loan agreements require you to disclose if you've borrowed or been given any part of the down payment. It could be illegal to fail to disclose the interest free loan)
The other portion would come from borrowing money from Newphew and his wife's 401k plans. Ed is concerned with the amount of interest that his nephew could save through the lower rate available in his 401k plan. Normally, I'd encourage that type of thinking. But, there are a couple of risks in using a 401k loan that could be much bigger than saving some interest.
Most 401k loans require a fairly short payback period. Nothing like the 20 or 30 years for most mortgages. So if you combine the mortgage payment and 401k loan payment, the earliest years of the mortgage will have the highest payments. That could be a problem.
Also, many 401k loans require that you pay them back completely if you leave your job. Even if it's not your choice to leave your job (read lay off or fired). That would put Nephew in a real bind. No income and a need to pay back up to $31,000 right now. Unless he has some other assets available (unlikely), he'll probably try to take a second mortgage against the house to repay the 401k loan. Finding a 2nd mortgage on his home could prove difficult. If not impossible. The only other options? Go to Uncle Ed for a second loan or let the 401k loan default. I have no way of knowing how a second Uncle Ed loan would work out. But, failure to repay the 401k loan means paying a penalty and income taxes on the unpaid balance of the loan. All of it. And, it also means that a bunch of Nephew's retirement money is gone forever.
So maybe buying this house isn't such a good idea. There might be a better option. Rent for a few years. Soon they'll be through repaying debt. Once that happens they can take the money that had been going to debt and begin saving up a down payment for the home. In a few years their credit score will improve. That will lower the interest rate on their mortgage (which will save them even more money). And, they'll also have some time to consider what they really need in a home. $300,000 buys a lot of house in most parts of the country. Something a little more modest might be in order.
Is it possible for Nephew to borrow money from his uncle, his 401k, buy this house and live happily ever after? Of course! But, with sub-prime mortgages defaulting all over the place you'd have to be Alfred E. Neuman to say "What, me worry?"
Keep on stretching those dollars!