Best Down Payment Option

[Anne Christensen]

Hello,

I have several ways to fund a down payment on my first investment property and would like to know the "safest" way to do so...

Cash, borrow against my 401K (and does this method constitue the start of my investments) or HELOC. My cash is in a high yeild savings account only making about 4.5%. I'm assuming this may be the best option. Any advice is greatly appreciated.

[Scott Trench]

I like the cash option. 

If you borrow $60K for the down payment from your HELOC, then even if you could get a 0% loan (it will be more like 7%+), you'd have to pay back $1,000 per month over the next 5 years. Now add interest. No property purchased with a $60K down payment will generate $1,000 per month in cash flow, unless you hit an absolute home run.

So, your portfolio will actually be sucking cash out of your life, if you buy a traditional long-term rental using a HELOC as your down payment, for many years.

The HELOC is a great tool when you are doing a large remodel, flip, or BRRRR, and plan to refinance to repay the HELOC. And, a lot of people got lucky with appreciation over the past 5-10 years. But, I would personally be very uncomfortable using a HELOC as a traditional down payment option.

[Michael Quarles]

I agree with Scott assuming it’s a traditional purchase where the goal is long term ownership and the knowledge base isn’t creative financing. 

That said I've bought a bucketload of property without a down payment or traditional financing. As you dive into REI learn seller financing, sub2 Syndications, even lease option strategies.

[John Bowens]

Anne, 

I will speak to your question with respect to borrowing against the 401(k). The rule of thumb is, only borrow against the 401k as a last resort option. Just as was mentioned above with the HELOC, I would use same philosophy with your 401k. The borrowing against a 401k could potentially come in handy for a fix-and-flip or BRRR type transactions as you can quickly return the funds to the 401k. Here are some important facts with respect to borrowing against the 401k:

1) It must be a 401k, once you rollover your funds to an IRA, you don't have that capability.

2) You can only borrow up to 50% not to exceed $50,000. 

3) You must make at least quarterly payments, with an interest rate set usually at prime + 1%. Your 401k administrator will help you set this up and usually you have to make monthly payments. 

4) If you default on your 401k loan, the entire balance is distributed to you, then you have to pay taxes and a 10% premature withdrawal penalty. In my research, default rates are pretty high amongst 401ks loans. 

5) If you leave your employer and want to rollover your remaining balance to an IRA to be able to invest in real estate, known as a self-directed IRA, you have to either A) Payoff the loan first, or B) When you rollover funds, the loan balance will be immediately distributed to you, thus taxes and penalties, and you forfeit all that tax-advantaged money back in the account.

6) 401ks are generally covered under federal ERISA rules, which affords you additional creditor protections, from outside of the 401k judgments. In other words, if there was a judgement against you, very difficult to impossible for them to come after your 401k money. 

7) Your 401k avoid probate when passing onto your heirs. 

Everyone's circumstances are different, so maybe it makes sense for you to borrow against the 401k, but I just think it is important that folks are fully educated on all factors before making that decision. 

Congratulations in advance purchasing your first rental property! As an investor myself, I can say, first transaction is always the most challenging and then each one gets easier. 

[Joe Norman]

I really dislike the idea of borrowing down payment money. If you have money saved up use that, and if you don't then save up.

[Brandon Croucier]

If you've got the cash, use the cash.

No reason to leverage 100%, your most likely going to be chucking out more money than whats coming in.

[Andrew Syrios]

I would go with the cash option. If you're making 4.5% now, you'll pay more servicing the debt on a HELOC. If you need more money or want to do a second property, you can always go to the HELOC at that point.

[Anne Christensen]

Quote from @Scott Trench:

I like the cash option. 

If you borrow $60K for the down payment from your HELOC, then even if you could get a 0% loan (it will be more like 7%+), you'd have to pay back $1,000 per month over the next 5 years. Now add interest. No property purchased with a $60K down payment will generate $1,000 per month in cash flow, unless you hit an absolute home run.

So, your portfolio will actually be sucking cash out of your life, if you buy a traditional long-term rental using a HELOC as your down payment, for many years.

The HELOC is a great tool when you are doing a large remodel, flip, or BRRRR, and plan to refinance to repay the HELOC. And, a lot of people got lucky with appreciation over the past 5-10 years. But, I would personally be very uncomfortable using a HELOC as a traditional down payment option.

[Anne Christensen]

Thanks so much for the advice Scott!  I've been listening to ALL the BP podcasts and the information is awesome, but sometimes overwhelming.  So glad the have the forum to get some clarity.  :) 

[Anne Christensen]

Quote from @Michael Quarles:

I agree with Scott assuming it’s a traditional purchase where the goal is long term ownership and the knowledge base isn’t creative financing. 

That said I've bought a bucketload of property without a down payment or traditional financing. As you dive into REI learn seller financing, sub2 Syndications, even lease option strategies.

[Anne Christensen]

Thanks for your reply Michael!  As I'll do some more research on your suggestions.  For now, I'll go with the cash option.  

[Anne Christensen]

Quote from @John Bowens:

Anne, 

I will speak to your question with respect to borrowing against the 401(k). The rule of thumb is, only borrow against the 401k as a last resort option. Just as was mentioned above with the HELOC, I would use same philosophy with your 401k. The borrowing against a 401k could potentially come in handy for a fix-and-flip or BRRR type transactions as you can quickly return the funds to the 401k. Here are some important facts with respect to borrowing against the 401k:

1) It must be a 401k, once you rollover your funds to an IRA, you don't have that capability.

2) You can only borrow up to 50% not to exceed $50,000. 

3) You must make at least quarterly payments, with an interest rate set usually at prime + 1%. Your 401k administrator will help you set this up and usually you have to make monthly payments. 

4) If you default on your 401k loan, the entire balance is distributed to you, then you have to pay taxes and a 10% premature withdrawal penalty. In my research, default rates are pretty high amongst 401ks loans. 

5) If you leave your employer and want to rollover your remaining balance to an IRA to be able to invest in real estate, known as a self-directed IRA, you have to either A) Payoff the loan first, or B) When you rollover funds, the loan balance will be immediately distributed to you, thus taxes and penalties, and you forfeit all that tax-advantaged money back in the account.

6) 401ks are generally covered under federal ERISA rules, which affords you additional creditor protections, from outside of the 401k judgments. In other words, if there was a judgement against you, very difficult to impossible for them to come after your 401k money. 

7) Your 401k avoid probate when passing onto your heirs. 

Everyone's circumstances are different, so maybe it makes sense for you to borrow against the 401k, but I just think it is important that folks are fully educated on all factors before making that decision. 

Congratulations in advance purchasing your first rental property! As an investor myself, I can say, first transaction is always the most challenging and then each one gets easier. 

[Anne Christensen]

Thanks so much for all the detailed clarification on the 401K option John.  This is great info and sounds like there is really no reason to go down this path.  

Excited and nervous about the first puchase!  Thanks for the well wishes. 

[Anne Christensen]

Quote from @Andrew Syrios:

I would go with the cash option. If you're making 4.5% now, you'll pay more servicing the debt on a HELOC. If you need more money or want to do a second property, you can always go to the HELOC at that point.

[Anne Christensen]

Thanks for the info on the HELOC Andrew! I'm getting clearer on the ways and timing of using each option and you've helped a ton. :)

[Andrew Syrios]

Quote from @Anne Christensen:

Thanks for the info on the HELOC Andrew! I'm getting clearer on the ways and timing of using each option and you've helped a ton. :)

 Sure thing Anne, happy to help and good luck!

[V.G Jason]

Quote from @Scott Trench:

I like the cash option. 

If you borrow $60K for the down payment from your HELOC, then even if you could get a 0% loan (it will be more like 7%+), you'd have to pay back $1,000 per month over the next 5 years. Now add interest. No property purchased with a $60K down payment will generate $1,000 per month in cash flow, unless you hit an absolute home run.

So, your portfolio will actually be sucking cash out of your life, if you buy a traditional long-term rental using a HELOC as your down payment, for many years.

The HELOC is a great tool when you are doing a large remodel, flip, or BRRRR, and plan to refinance to repay the HELOC. And, a lot of people got lucky with appreciation over the past 5-10 years. But, I would personally be very uncomfortable using a HELOC as a traditional down payment option.

Agreed, this whole HELOC for downpayment thing needs to stop. If you don't have appropriate funds to enter a physical asset-- meaning physical risks, humans to manage, etc., then it's best to wait until you do or invest in a REIT.

You're just not fit...right now. That could change, work on that change. This is a whole new era than 2010-2020, you're going to have to come correct not just straight spec.

And you're not making 4.5% on your HYSA--that's gross. Take out the tax, you're closer to the 3%. You're just mirroring inflation.