Welcome to my monthly installment of things I would never do. I started this series last month to shed light on some maybe unwise practices that may not always be the best idea from a financial perspective. Again, it’s not meant to be judgmental in nature but more informative and possibly humorous. Last month I discussed the car loan industry and the insanity of a 97 month car loan. I received some good feedback on it, so here’s to hoping for more of the same.
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The issue that I am looking at this month comes from a Yahoo Finance article I read a few weeks ago that covered the topic of amateur investors increasingly raiding their 401k(s) and retirement accounts to purchase property. The story highlighted a 48 year-old woman, with heart disease, who took a $50,000 loan against her 401k in order to purchase an investment property. The lady was quoted as saying that since she has heart disease she’s looking to further diversify and views purchases like this as life insurance. I’ll readily admit that while many should have life insurance, it’s not a necessity for all, and last I checked real estate was not life insurance. The ultimate driver behind this, as quoted by one analyst, was that people are lacking trust in the stock market and thus viewing the hard asset of real estate as the appropriate destination for these funds.
Should We View our 401k as a Coffer?
I’ll readily admit that investing in the stock market is not for everyone and there is real fear out there amongst investors who lost a big chunk of their portfolios during the Great Recession. That fear is real, but does that really mean that we should avoid it altogether? No, it doesn’t. The point though, is that while it may be convenient to take loans against your 401k and there may be times where it may be beneficial to you, your 401k should not be viewed as a coffer from which to take money out and throw it at other things. The inherent problem behind taking a loan from your 401k is with changing jobs or encountering unemployment; you run into the risk of early withdrawal fees if you’re younger than 59 ½ as well as income tax on any unpaid portion of the loan. When you’re talking about tens of thousands of dollars in a 401k loan then you’re potentially talking about a decent chunk of money, not to mention the risk of loss of value in real estate.
Diversification is Good – to a Point
I’m not meaning to bemoan owning real estate as we know people who invest in real estate. I think that owning real estate is a great way to further diversify your investing. If we had the time and resources in the Frugal Rules home then we would likely look at it. The housing market has been showing signs of being on an upswing and I think it can be a great tool to use as you seek to build wealth. That said, the article cited that 401k raiding is increasing and that some people are looking to purchase multiple properties. I think it’s great to pursue something like this, as long as it’s in your best interest. As opposed to raiding retirement accounts why can’t there be an option to raise the cash outside the 401k and use that as a down payment on a house? I guess my point is that, as with any type of investing, there needs to be balance.
The Problem of Following the Herd
The real issue I have with this growing practice is the problem of following the herd mentality. Herd mentality thinking can take place in various scenarios and we see it all the time in the stock market and we’re seeing it here. The article stated that there has been so much demand for real estate that property prices are starting to rise. Not only are individuals snapping up properties, but Wall Street has taken notice; hedge fund managers to private equity investors to foreign investors are all snapping up property because prices are going up. Added to that, many of these properties are also located in the same locales that were going crazy prior to the downturn – Las Vegas, Phoenix and several cities in Florida. All of this has resulted in many retail investors seeing as little as 2% return, if they’re lucky, by chasing after this real estate. What all this means for those that are raiding their 401k(s) to try investing in real estate is that they are, generally, playing with fire for little potential return and are taking a major risk with their retirement planning. For those that do not have a solid cash cushion or willingness to deal with the unique problems surrounding owning real estate, they could end up in a situation where they’re unable to repay their 401k loans. Additionally, they also have to deal with the real possibility that they could earn a much better return by simply staying in the market.
Please don’t get me wrong, I believe that investing in real estate can be a great thing but it needs to be done within reason just like investing in the stock market. The issue is that investors need to do what’s right for their specific situation and not chase gains, wherever those may be, because they see others doing it. I know that not all people who take loans from their 401k(s) will end up miserably, but it is not a risk I would take on without doing my research first.
What are your thoughts? Would you borrow against your retirement accounts to fund a real estate purchase?
Photo courtesy of: Sherwood CC