A TSP Loan: Worst Idea Ever?
Let’s get this out of the way up front: the vast majority of financial planners will tell you to NEVER borrow from your TSP, so this might be one of my more controversial articles. And don’t misunderstand this paper to mean I wholeheartedly recommend TSP loans. However, rarely have I come across a piece of financial advice that can be dogmatically applied to everyone, in all situations. And a TSP loan is no exception. I have seen TSP loans actually improve an individual’s financial situation and become an important part of their financial plan. I will attempt to explain the TSP loan process, the pitfalls, and in what situations the loan may be an appropriate tool for you.
How do I borrow from my TSP?
First, familiarize yourself with the loan process by reading the TSP literature. I have posted several resources at the end of this article to provide more detail. But here is the general idea:
Choose the type of loan. There are two: General and Residential. A general loan can be for any reason and is repayable on a period that YOU CHOOSE between 1 and 5 years. A residential loan must be for the purchase of your primary residence and the repayment period may be between 1 and 15 years—again, you choose the length.
Determine how much you can borrow. TSP will tell you this. You are limited to your contributions and earnings, or the IRS-imposed limit of $50,000. And you can never take out more than 50% of your balance. (Unless the TSP adopts the CARES Act provisions). The easiest way for you to determine your available loan amount is simply to log onto your TSP and click “TSP Loans” on the lefthand side of the screen. It will tell you your maximum loan amount available.
Complete the online application on TSP’s site once you log in, or complete the paper FORM TSP-20. If you are FERS, and you are married, your spouse will have to sign his/her consent prior to you receiving the loan. If you are applying for a residential loan, you will have to submit additional documentation regarding the residence.
Review ALL literature and paperwork before submitting the final request.
Receive the loan. Generally it takes a few days for the money to arrive in your account once the paperwork has been finalized. In fact, the whole process is rarely more than 2 weeks, and many times it is much sooner. The TSP reports distributions in 7 to 10 days, but my experience has been that it is much sooner.
Monitor your loan balance through the TSP site as you do your TSP balance now. Payments are deducted from your paycheck, although you can send in additional payments to pay the loan down faster, or request a payoff amount to eliminate it completely if you have the money.
So, what are the costs/drawbacks?
Known Costs.
First, let’s talk about the costs easiest to quantify: application cost ($50) and interest rate (currently at .875% as of 04/30/20). The application cost is a one-time fee and deducted automatically from your account. The interest rate is constantly fluctuating (until you take out the loan, and then your rate is fixed for the life of the loan), and it is basically the G Fund return rate. If you want to verify the current loan rate (which happens to be the same interest rate if you are one of the ones tricked into purchasing a TSP annuity), simply click on “Loan and Annuity Rates” under QUICK LINKS, on the TSP home page at the bottom left of the page.
The $50 application fee is gone—you don’t recover it. It’s a lost cost. The interest on the loan however is unique, because unlike a credit card, student loan, or mortgage, the interest isn’t going to a bank, it’s going back into your TSP. Neither the repayment nor the interest is tax deductible, but they are both going into your account. We’ll touch more on this later, as it becomes an important factor in evaluating the appropriateness of a TSP loan.
Unknown Costs.
Next, let’s talk about those costs less quantifiable. These are the ones cited most often as reasons against taking out a loan from your TSP or 401(k): Opportunity cost is the big one. For those of you who actually had fun in college instead of study accounting like the rest of us, opportunity cost is simply money that you miss out on because you weren’t in the game. For example, if you take a $10,000 loan out, and the market goes up 15%, you “lost” $1,500 in gains that you would have otherwise made if you had left the $10,000 invested ($10,000 x 15% x 1 year). In other words, you can’t make money in the market if you’ve taken the money out of the market.
Some will argue that they didn’t exactly lose $1,500, they just didn’t make $1,500. While that is true, the net result from a math standpoint is the same, so it is generally referred to as a loss. And it should be. Because when we are comparing uses of money, we have to factor in all costs related to Option A vs. Option B so we can make the best decision.
Example:
Jim takes a $10,000 TSP loan at 2.000% to pay of a credit card with a balance of $10,000 at 18% interest. What are Jim’s costs? Well, he has a $50 loan fee, interest payments, and opportunity costs (we don’t know the exact opportunity costs right now because they are based on the POTENTIAL return of that $10,000 had it been left in the TSP). What are Jim’s benefits? Well, not only does he eliminate 18% interest on his credit card balance, the 2.000% interest rate he is now paying goes to him. Don’t miss that point—the interest goes into your TSP account. We’ll dive more deeply into how to analyze this later, but this is the basic structure of a cost/benefit analysis.
The other intangible cost is only a potential cost, but one that should be addressed nonetheless, because it can be quite damaging. If you separate from government service with an outstanding loan balance, the remaining balance is considered income and is taxable at your ordinary rate. If someone takes a $50,000 loan from their TSP and is either fired, resigns, or retires immediately, that $50,000 is considered taxable in that year. Hopefully they didn’t spend it all since the IRS wants some of it. If the person pays the loan down for a few years, and then separates, only the remaining balance is considered taxable and penalized, not the entire $50,000.
Again, while separation may be only be a potential cost, it can have far-reaching effects on an individual’s tax situation and must be taken into account. If you think you might be separating from the government soon, it is probably wise not to take a loan out.
Before we leave the subject of opportunity costs and missed gains, I want to bring something to your attention that I never hear the financial wizards explaining. Losing out on gains in the C Fund, for example, because you took a loan out, only occurs if the market goes up while your money is out of the account! If you withdraw your $10,000 and the market goes up over the two years it takes you to pay it back, well then yes, you’ve lost out on those gains you would have made. However—what if the market goes down during that same time period? Have you lost anything? NO! You’ve actually SAVED yourself money by not being invested in the market,and therefore subject to its losses.
Here’s how this works in real life: let’s say you took out a $20,000 loan in 2007, prior to the worldwide, stock market meltdown. 9 out of 10 financial advisers would have told you that was a bad idea. However, that $20,000 was protected from losing 30% of its value (C Fund) by virtue of the money not being invested; it was out of the market and in your pocket (hopefully working for you and not being blown at the Bellagio craps table).
If you’ve read my articles, you know I’m not a huge proponent of market timing, and believing the market is going to go down does not mean you rush out and take a TSP loan. I’m simply providing you with all of the facts. Over a given period of time, the market tends to move up, but full disclosure must include the fact that there have been times when the market has NOT gone up. Sometimes it has gone down. And sometimes significantly! These negative movements undermine the number one argument criticizing TSP loans. While opportunity costs must be an important part in any good analysis, it must also be considered that there will be no opportunity costs, particularly if the repayment period is as short as one year.
Let’s end with one more illustration:
On 1/1/18, Janet borrows $20,000 for a down payment on her house, which she expects to repay in 2 years. Janet was 100% in the C Fund due to the awesome performance over the last year or two. In 2018, the old adage, “What goes up must come down” finally rears its head, and the market drops 8%. In 2019, the market recovers, but only slightly, and gains 4%. By 12/31/19, Janet has paid off her $20,000 loan. What were her opportunity costs? $0. In fact, Janet saved herself some money by NOT having the $20k invested in the C Fund. Let’s recreate the scenario of the $20k by assuming Janet left it in the C Fund instead of taking out the loan. This would be the balance (of just the $20k we are talking about-not the entire account):
1/1/18: $20,000
12/31/18: $18,400 ($20,000 – 8%) Market went down 8%
12/31/19: $19,136 ($18,400 + 4%) Market went up 4%
Did Janet miss out on a significant amount of money over her lifetime? In this scenario, no.
Change the assumption and say that the market went up another 18% and then 10% in 2018 and 2019, what would have been Janet’s balance:
1/1/18: $20,000
12/31/18: $23,600 ($20,000 + 18%) Market went up 18%
12/31/19: $25,960 ($23,600 + 10%) Market went up 10%
Because that balance is larger now, it would continue to affect additional balances in the future (because of compound interest). You begin to see what the potential opportunity costs could be, and how large it could grow over the 20 years. But again, it is highly dependent on the market returns and how Janet had the $20,000 invested. If it were in the G Fund earning the same rate of return as the interest on the loan, the opportunity costs would be negligible over that time period.
I think that’s enough on opportunity costs.
So, is a TSP loan ever a good idea?
As I said before, it’s rare to have a piece of financial advice be applicable to all people, in all situations, at all times. Perhaps one could argue the phrase, “More money is always good” is universally true, but even then, we could all name people who let money ruin them and, frankly would have probably been better off with less money.
Is it smart to borrow from your TSP to go on a cruise? Probably not. What about taking out $50k to play the slots in Vegas? Again, no. A new car? Season tickets to your hometown football team? Responding to that Nigerian Prince’s email you just received? None of these things really better you financially. They don’t factor into a solid financial plan—in fact, they sort of indicate a complete LACK of a financial plan if you’re raiding your retirement fund to buy them. Hopefully everyone is with me so far. (Although, I have seen a couple of the above examples personally.)
But let’s take this situation: Megan is 28 years old and has $6,000 in student loans at 8%, $2,000 in credit card debt at 15%, and a $4,000 car loan balance at 6%. Depending on the terms and initial balances, a fair estimate of the total of these payments could be approximately $450 a month. Let’s assume all of these debts will be paid off in 5 years if she continues with the minimum payments.
What are Megan’s options? Well, she can continue to pay the balance every month and eventually have them all paid off. In the meantime, she will be paying a lot of money in interest, and she’ll delay being debt free for some time. She could probably fairly easily transfer the credit card debt to a card with a more reasonable rate. Refinancing the car is probably not worth it at this point since the balance is relatively low, and she is not looking to extend payments farther out. She wants to be out of debt sooner, rather than later. She could sell some things around the house and apply the proceeds to the balance. Craigslist and eBay have helped more than a few people get out of debt.
A second job would be a good option, if it’s feasible. So would simply tightening the belt and trimming expenses so that extra payments could be made, eliminating the debt sooner. Perhaps even a low interest rate home equity loan could be made to consolidate the debt at lower rate. This assumes she owns a home.
All of these are viable plans, and should be explored. None of them have the effect of potentially hurting her retirement account. However, we’re here to discuss the TSP option, so let’s take a look at it:
She could apply for a TSP loan in the amount of $12,000 (the outstanding balance of all loans). Given the current interest rate is .875%, a 5-year loan would equal monthly payments of $204.48. Let’s assume however, Megan is not trying to get her payments as low as possible,she’s actually trying to become debt free and build real wealth. Since she knows she can AT LEAST afford $450 a month since she’s already making those payments. So she applies the $450 a month to the TSP loan. Any guesses when that loan is repaid? In 2 years and 3 months.
Assuming Megan does not incur additional consumer debt, she’s free in 2 years and 3 months-- much sooner than she would have been had she kept making the minimum payments. In addition, instead of paying banks the interest, she paid herself the interest. And at a much lower rate, which is why the loan is paid off so early. (I said there aren’t many dogmatic statements in personal finance, but here’s one most would agree on: paying less interest is better than paying more interest).
What about opportunity costs for Megan? Megan withdrew $12,000 from her TSP, so assume it was invested in the market (and at 28 years old, I would sincerely hope she wasn’t in the G Fund), and assume the market went up. Yes, she would have the opportunity costs of whatever gains she would have made. Let’s just use an average market return of 8% a year for illustration purposes. That is roughly $2,000 she lost out on over those two years. (Actually it would be less, because the $12,000 wasn’t out the entire time, she was putting it back monthly starting the very first month, but $2,000 is a nice round number.)
So, now Megan has $2,000 less in her TSP than she would have had had she not taken out the loan. At 8% a year average market return over her career, that $2,000 could be a substantial amount of money (see below). And again we are back at the reason why financial advisers criticize this strategy.
But wait a second—8% a year return is a big assumption on our part regarding the market’sperformance over the next two years. Also, what about the fact Megan is out of debt now and can afford to apply $450 a month to increase her TSP or other wealth-building vehicle? Potentially for the rest of her career? Doesn’t that count for something? And what about the interest she saved? And the fact that the interest that she did pay went to her, and not to some bank? And, finally, what about the intangible feeling of empowerment and freedom that being out of debt brings? Are we saying none of that’s worth mentioning?
No, certainly not. And those are the points that each of you have to analyze thoroughly to decide whether a TSP loan is right for you. Will it improve your overall financial position? Let’s put some numbers to this example to see:
1. $2,000 opportunity cost at 8% a year compounded for 20 years equals $9,500. This is the amount we mentioned above when we figured how much Megan would lose in opportunity costs if she took the loan out.
2. Assuming Megan paid off her debt 3 years earlier using the TSP loan, that is 3 extra years she could invest $450 a month at 8% a year. That would equal over $18,000.
That opportunity cost continues to grow over her lifetime because of the compound interest principle. But you know what? So does the savings she built by paying off debt early. You can easily see above which would have been better in the long run.
I’ve thrown a lot of math at you. And understand all of it is a representation of different interest rates and terms, although there is no intended trickery in any of this—the payment estimates and payoff times are very reasonable estimates. But each of you has to analyze your particular debt(s) to see if a TSP loan for debt payoff is beneficial. It is best if you work with your professional financial adviser on this, or call me and I’ll walk you through it. The bottomline is you need to analyze everything and understand the pros and cons of each approach.
SUMMARY
Many years ago, I read that one should “never sacrifice the permanent on the altar of the immediate.” The need for instant gratification is a weakness in our society today that undermines virtually every aspect of our lives. The inability to simply say “no” is why we are broke, out of shape, and wasting much of our lives in front of a screen watching videos of cats. Remember that the TSP is meant for your retirement. It is not designed to work as a checkbook. Or even as a traditional savings account. It is not meant to be spent, so much as it is meant to be lived on, when you are no longer making a living. As such, you should seriously think before rushing to pull money out.
While I’m not totally against TSP loans, I would caution anyone against taking one out without understanding fully the potential consequences. Likewise, I would discourage damaging your retirement for something as frivolous as a vacation or a new boat, or anything of that nature. However, if you’re drowning in high-interest consumer debt that is stressing you out and causing problems in your life (financial or otherwise), it may be something to kick start your financial turnaround.
Lastly, it has been my personal experience that those that have attacked debt aggressively (myself included) have been able to accumulate wealth much faster than those who have not. Borrowing seems to hurt way more than it helps, so take a good hard (and honest!) look at your financial picture before you borrow anything else, be it from your TSP, from some new credit card offer you just got in the mail, or the special deal they have going on right now at the Harley dealership.
Some final things to remember:
You may only have one loan of each type at a time. And you must wait 12 months after the loan is repaid before you can get another one—remember, it’s not a checking account.
The interest rate of the loan is the G Fund rate of return.
All interest goes into your TSP account.
If you separate from government service, or you don’t pay the loan back, it is taxable
and may be subject to a 10% penalty if under 59 1⁄2.
A spouse has to give consent (if married)
Read, read, and re-read everything before taking out a loan. Seek professional advice.