Should You Borrow Money to Fund a Retirement Account?

Some links below are from our sponsors. Here’s how we make money.

Advertiser Disclosure: Opinions, reviews, analyses & recommendations are the author’s alone. This article may contain links from our advertisers. For more information, please see our Advertising Policy.

default sharing image
I recently had one of my Prosper loans paid in full. I invested $125 with a borrower who wanted to borrow $24,000 to fully fund his SEP IRA, a retirement plan often used by small businesses and self-employed individuals. Borrowing money to invest sounds risky, and it can be. But there are two interesting sides…

I recently had one of my Prosper loans paid in full. I invested $125 with a borrower who wanted to borrow $24,000 to fully fund his SEP IRA, a retirement plan often used by small businesses and self-employed individuals.

Borrowing money to invest sounds risky, and it can be. But there are two interesting sides of this story, and I’ll share a little bit about the pros and cons of both sides – from a borrower’s and lender’s perspective. From there, you can make your own decisions regarding what you would do in either situation.

Note: Prosper is a peer to peer (P2P) lending company, like Lending Club, in which people like you and I can fund loans for our peers (You can “be the bank”). Like many other investments, P2P loans are not guaranteed and there is associated risk.

Using Leverage for Investing

Using leverage to invest basically means borrowing money to make an investment. You are hoping that in the long run, you will be able to earn more money with your investment than you pay out in interest. A similar tactic is trading on margin, which is stock trading with borrowed money. But using leverage is not limited to stock trading; it can mean borrowing money to purchase a rental property, buy a business, or in this case, fully fund a self-employed retirement account.

Borrowing Money to Invest

Normally, I wouldn’t recommend borrowing money for investing unless you have a very good idea of the outcome. Personally, I wouldn’t trade stocks on margin because I’m not good enough at the stock market game to make short term trades with borrowed money.

However, there are some instances where it may not be a bad idea. For example, if you know what you are doing, then buying a rental property with borrowed money can be a great way to create a positive cash flow opportunity. The same thing can apply to buying a business with borrowed money and many other opportunities. But these situations are often less volatile than short term stock trading.

Should You Borrow Money to Fully Fund a Retirement Account?

As with any investment, there are risks. If you borrow money for retirement investing, or any other investing, you should have a clear idea of when you will be able to repay the loan, and limit the amount you borrow to be able to repay it as quickly as possible. Here are some pros and cons, with the negative possibilities listed first.

Cons. Investments are not guaranteed, and can lose value. Using borrowed funds to invest magnifies your potential for loss. Additionally, starting out by paying interest on the money used for your investments means you are starting in the hole and need to earn more money to break even. This last fact is mitigated by the long term nature of retirement investments, and the short term nature of the loan.

Pros. Many retirement contributions, including a SEP IRA contributions, are tax deferred, which means the contributor won’t pay taxes on those funds for that tax year. You also only have one shot at retirement investing each year – if you don’t make the investment before the contribution deadline, you can’t go back and put in money in for that tax year. A $24,000 contribution can substantially lower taxable income and save the borrower several thousand dollars the year the contribution is made, and maxing out his retirement plan gives more time for compound growth opportunity.

Why I lent Money to Fund a Retirement Account

Even though there is risk involved with this type of loan, I was intrigued enough to lend the borrower the money. Here is the purpose of loan, from the listing summary at Prosper:

I want to fully fund my SEP IRA. My company does not have a 401K and as such, a SEP-IRA is an excellent option. Particularly, I would like to make sure that I fully fund the SEP IRA for the pretax benefits.

The maximum contribution for SEP IRAs was $46,000 in 2008 when the loan was originated. The borrower needed $24,000 to fully fund his SEP IRA, which means he was able to fund $22,000 on his own. That gave me some confidence in his ability to pay off his loan. I also knew that he was employed in the software engineering industry, and I have seen some of the work he has done, which is impressive. Should he have lost his job, he would probably have been able to find work.

More borrower information. Prosper lists other financial information about borrowers, including their credit score, length of credit history, total number of open credit lines, amount of revolving credit, and more.

The borrower had an excellent credit score, a AA credit rating, a reasonable amount of debt, reasonable number of credit lines, owns his home, no delinquencies in the last 7 years, and other favorable information. In short, he looked like a good bet to pay off the loan in full.

More about the loan. The rate of the P2P loan was 9%, which offered much more opportunity for return than I would be able to receive from a standard savings account. The loan was paid in full this month, and in the almost 2 years it was open, I received just over $15 ROI ($140.57 on a $125 year loan). I would have earned more had the loan not been paid off early. While there are no perfect investments, I was satisfied with the amount of risk I took on and I am more than happy with the results.

My returns with P2P lending at Prosper. My average weighted yield from Prosper is 11.38%. Looking back, I should have seen that interest rates would continue to drop, and I wish I would have invested more money in this, and similar loans.

What Are Your Thoughts?

Do you think taking out a 9% loan to fully fund a SEP IRA was a reasonable investment on the borrower’s side (note that he paid it off just over 1 year early, so he had confidence in his ability to repay the loan). What about from a lending perspective?



Get Instant Access
FREE Weekly Updates! Enter your information to join our mailing list.

About Ryan Guina

Ryan Guina is the founder and editor of Cash Money Life. He is a writer, small business owner, and entrepreneur. He served over 6 years on active duty in the USAF and is a current member of the IL Air National Guard.

Ryan started Cash Money Life in 2007 after separating from active duty military service and has been writing about financial, small business, and military benefits topics since then. He also writes about military money topics and military and veterans benefits at The Military Wallet.

Ryan uses Personal Capital to track and manage his finances. Personal Capital is a free software program that allows him to track his net worth, balance his investment portfolio, track his income and expenses, and much more. You can open a free account here.

Reader Interactions

Comments

    Leave A Comment:

    Comments:

    About the comments on this site:

    These responses are not provided or commissioned by the bank advertiser. Responses have not been reviewed, approved or otherwise endorsed by the bank advertiser. It is not the bank advertiser’s responsibility to ensure all posts and/or questions are answered.

  1. Kyle says

    I don’t think borrowing money to invest is a good idea at all, especially for a retirement account. If somethng had happened and he had to repay that loan out of his retirement account he would have to pay a penalty on the withdrawl plus the interest on the loan. Your best bet is to fund what you can each year and accept the fact you may not be able to hit the maximum contribution.

    • Ryan says

      In this case, I can see why he did it – the tax difference was fairly substantial (no income tax on $24k) which is beneficial if he didn’t have the cash to pay that in a month or two. He also added a huge amount of money to his retirement account, which gives more time for compound interest to work. It also depends on his earnings expectations for the coming months/years. I’m not certain I would have done it for myself, but I can understand why someone would choose to do it.

      In the end, it looks like it worked out fairly well for everyone involved.

  2. Monevator says

    I think this is a great article that goes beyond the knee-jerk “bad idea” which would certainly be my first response.

    (I’m still minded to think it’s a risky idea, but you do a great job at presenting the other side here Ryan, IMHO).

  3. Randy says

    One way to look at such questions is to flip them over. Would you use money for your retirement account to pay off part of a home loan early? Probably not.

    Would you use money otherwise going into a 401(k) and use it to pay off a second (line of credit) on a house? Maybe but probably not.

    Would you borrow against a house at about 5% (with a tax deduction for interest payments) to make up for income plowed into a 401(k), which also earns a tax break? Probably not.

    If you re-fi at a lower rate, would you use the savings to pay down the principle on the home loan or fund retirement? Probably fund retirement.

    Why? These are all the same basic proposition — tradeoff in increasing home equity vs. funding retirement savings. But somehow seems riskier when actively taking out a new home loan to fund a retirement account. But the difference seems mostly psychological. (Granted, when you pay down a fixed loan, you don’t see a monthly savings, you just pay off earlier — but that translates to investing at 5% outside a retirement account).

Load More Comments

Disclaimer: The content on this site is for informational and entertainment purposes only and is not professional financial advice. References to third party products, rates, and offers may change without notice. Please visit the referenced site for current information. We may receive compensation through affiliate or advertising relationships from products mentioned on this site. However, we do not accept compensation for positive reviews; all reviews on this site represent the opinions of the author. Privacy Policy

Editorial Disclosure: This content is not provided or commissioned by the bank advertiser. Opinions expressed here are author’s alone, not those of the bank advertiser, and have not been reviewed, approved or otherwise endorsed by the bank advertiser. This site may be compensated through the bank advertiser Affiliate Program.