Question: I wanted to take out a loan on my 401k and use it to purchase a small > vacation home. I want to know if the interest can be deducted on my > return as morgage intrest or must I obtain a “mortgage” from a bank?
Answer: It is dangerous to use a 401K loan in this manner. If you were to lose your job for any reason, the 401K loan would be due and payable on the spot. With a loan large enough for a home, I would assume that you do not keep that much cash in your checking account. So, you would be forced to look for a loan to pay back your 401K at exactly the worst possible time…just after losing your job. Not good.
I would still get a mortgage or home equity loan on the property. Rates are low right now, so it isn’t that costly to do so. That also solves any question about the mortgage interest being tax deductiable. If you cannot afford to pay the loan as-is, then consider tapping your 401K for loans on an annual basis, and pay regular payments on the home. This minimizes the money that you borrow out of the 401K, lets you earn a bit of interest on the 401K money between the loan and when your home payments are due, and it keeps your 401K loan risk exposure low. Now, if you were to lose your job, you have a much smaller 401K loan to worry about, if you have any at all, and you can use credit cards, severence, or a home equity loan to repay the now much smaller 401K loan.
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