The TSP Loan Guide

TSP home loan - Thrift Savings Plan Loan GuideI have received a surprising number of emails since I started this blog on the subject of Thrift Savings Plan loans, most along the lines of “I am this situation, should I get a TSP loan?” or “Everyone says that you should never borrow from your retirement account, but…” My colleagues with an interest in financial matters and I have debated the various scenarios under which someone might consider a TSP loan over the years, and I have watched a few co-workers make what I considered to be some tragic blunders. So in this post I will share my opinions regarding when a TSP loan might be a good idea, some thoughts for alternate sources of loans, and finally a breakdown on the TSP loan process.

Part 1: When Should You Consider a TSP Loan?

At the outset I should start with an overarching idea: you can borrow to pay for anything in life with the exception of retirement. You can get a loan for a house, a car, school, even vacations. But you can’t borrow money to live on after you have stopped working and no longer have an income. For that reason, it is crucial for you to fund your TSP account to the maximum amount possible based on your financial position. And of course by extension, that means that you need to keep it funded as fully as you possibly can so that you can take advantage of the power of compounding, tax-deferred gains over the years.

In the US, an astounding 20 percent of all 401(k) participants have outstanding loans from their retirement savings according to the Employee Benefits Research Institute (the 401(k) is a non-government sponsored retirement savings plan which closely mirrors the FERS Thrift Savings Plan). Most Americans do not save enough for retirement in the first place, and when they pull that money out it is no longer accumulating and growing for their retirement needs.

That said, the existence of the TSP loan program provides some benefits to you whether you ever use it or not (as I will explain below), and I do believe that sometimes a TSP loan may be the best option for some people as they dig out from hard times or bad decisions, or to provide a quick and inexpensive bridge to a better financial position.

TSP Loan Availability Eliminates the Need for an Emergency Fund

Before we discuss the pros and cons of a TSP loan, let’s look at one great advantage that the availability of TSP loans gives you in planning your finances. Many financial planning guides recommend that you set aside an emergency fund of three to six months worth of expenses. For a typical worker with a family, a car payment and a mortgage, that could easily exceed $30,000. The emergencies you are preparing for with this contingency fund are either (1) income being dramatically reduced or eliminated, or (2) very large, unexpected expenses being incurred. These are catastrophic events such as the primary earner being laid off, a death, or a serious illness or injury. Fortunately, these types of events befall only a very small percentage of workers. Most Feds with emergency funds put that money where it is safe and easily accessible, but with savings and money market accounts paying under 1% (which is much less than the rate of inflation), they are effectively losing money by doing so.

The easy availability of up to $50,000 (typically within two weeks for most TSP loans), coupled with the fact that federal workers have virtually no chance of being laid off and so income will generally keep flowing in during most crises, eliminates the need for Feds to maintain a separate emergency fund.

I don’t actually see this availability as eliminating the emergency fund, but rather making your Thrift Savings Plan the place where you are going to put your emergency fund. You want to get the best return on the money in your emergency fund, so do you put it into a bank account or money market account where you will make less than 1%, or do you put it into a tax-advantaged account from which you can access it if you need it?

If you aren’t already making the maximum TSP contribution of $17,500, I think that where to put those funds is a fairly simple decision. If you put your emergency fund into your TSP you get to put pre-tax money into an account which will grow and compound tax free until you withdraw it, but you can still get to it if you really need to. If you are already making the maximum contribution, then I think that you should look at other tax advantaged accounts such as Roth IRAs from which you can easily pull it back out if necessary (although then of course you don’t have the option of returning it).

As an aside on alternative emergency funds, most people don’t realize that if they have a Roth IRA (which we will discuss in detail in a later post), they can withdraw their own contributions at any time without tax or penalty. This is because they paid tax on the contributions prior to putting them into the IRA, so there is no additional tax or penalty to withdraw it. This “free” withdrawal is limited to contributions. If you withdraw earnings early you will pay income taxes plus a ten percent penalty, which could add up to nearly to half of the money which you are withdrawing (unless you do what is called a qualified distribution). A major disadvantage to withdrawing contributions from a Roth IRA, however, is that you cannot pay back the funds which you withdraw so that contribution which was earning and compounding tax-free can never be replaced.

A TSP loan is only an option for those who are in active pay status, so if the emergency has resulted in you not being paid (you are on extended leave without pay after exhausting all of your sick leave while caring for a sick relative, for example), a TSP loan is not going to be an option. But you can still access the funds in your account through a financial hardship withdrawal. This is a withdrawal made while you are still employed based on genuine financial need. You must pay income tax on the taxable portion of the withdrawal, and, if you have not reached age 59 ½, you will pay a 10% early withdrawal penalty. With a financial hardship withdrawal, you cannot resume making contributions to your TSP for 6 months, which means that you will not receive matching contributions during that period if you are a FERS employee. There is a lot more information on in-service TSP withdrawals in the Thrift Savings Board’s In-Service Withdrawals publication.

The availability of these alternate sources of emergency funds means that you can put the money which otherwise would have been tied up in an emergency fund to work for you now by paying off high interest rate debts, increasing your Thrift Savings Plan contributions, and contributing to non-TSP investment accounts (typically in that order).

When is a TSP Loan a Good Idea?

As we discuss under what circumstances a Thrift Savings Plan loan might be appropriate, three major themes emerge:

  1. Any TSP loan should be taken only for a short duration, and paid back as quickly as possible;
  2. TSP loans should not be taken for things that you want (i.e., a new car, a vacation, a wedding, or a bigger house than you can really afford), but rather to put yourself into a better financial position which will help you with your goal of preparing for retirement;
  3. TSP loans should never be used when there is another, low-interest rate alternative which would serve the same purpose.

Situations in Which TSP Loans Make Sense

There are two general situations in which I believe that a TSP Loan may make sense.

(1) Consolidate and lower the interest rate on high interest debt: 99% of the time when we talk about high interest debt, we are talking about credit cards. There are a lot of reasons why people wind up with credit card debt. Some do it from necessity, some because they lack self-control, and some because they don’t realize that there are less expensive options available in their situations. Whatever the reason, the impact can be devastating on two fronts. First, with the high interest rates charged by many card issuers, minimum payments may be made up almost exclusively of interest so the cost of that loan (a credit card balance is a loan) can wind up being more than the loan itself and it can take many years to pay down the debt. And second, carrying high balances on credit cards impacts credit scores, which makes it much more expensive (and sometimes impossible) to obtain credit, may result in landlords refusing to rent to the individual, may result in higher car insurance premiums, and may result in adverse consequences for those who have or attempt to get security clearances.

credit-cards Thrift Savings Plan Loan GuideThe benefits which I see to taking out a TSP loan in some of these situations include:

  • paying down debt more quickly and less expensively allows for higher TSP contributions;
  • automated payroll deduction forces payments for those with poor discipline who might otherwise skip payments or make minimum payments;
  • elimination of credit card debts will immediately improve the borrower’s credit score.

I believe that Feds should take out a TSP loan to reduce their high interest debt only if there is no alternate source of reasonable interest funding available. Before you take out a TSP loan to pay down high interest debt, explore your options:

  • borrowing money from family members;
  • home equity loans or lines of credit (if you own property);
  • signature loans from your credit union or other financial institution.

USAA generally provides very good loan rates and excellent service for those who are eligible to join (anyone who has served honorably in the US military as well as many of their family members).

(2) Use a TSP loan as a temporary bridge loan when purchasing property: Real estate transactions often result in a need for relatively large amounts of cash which can be quickly replaced or paid back following the closing of the transaction. Commonly encountered examples include when funds needed for your down payment are tied up in another property which has not yet been sold, the need to round out a down payment to avoid having to buy private mortgage insurance, payment of taxes, closing costs, etc.

TSP home loan -  Thrift Savings Plan Loan GuideOther sources of low cost funding may not be available at a time when a borrower is applying for a large mortgage loan, or they may prefer not to show more debt on their credit report at a time when their mortgage lender is setting interest rates and deciding whether or not they qualify for the loan.

The TSP loan does not appear on credit reports as a loan, and because it is your money you do not have to report it as a loan on your mortgage application (you can’t borrow money from yourself, after all). If you are required to provide the source of funds, these funds are from your retirement savings. Even if your lender is not familiar with the Thrift Savings Plan, they are very familiar with similar 401Ks and the mechanisms for drawing on those retirement plans to purchase property.

The key to using a TSP loan in this situation is that you must be committed to using it only as a short-term bridge loan. You need to be ready to replace the funds and repay your Thrift Savings Plan account with money from sale of another property or with a home equity loan, home equity line of credit, or other second mortgage in relatively short order. (It is worth noting here that interest on theses loans and lines of credit which are secured by your property is tax deductible, whereas the interest you pay on a TSP loan is not).

There are an endless variety of other scenarios out there which I have not discussed above. When you are deciding whether or not a TSP loan is appropriate in your circumstance, remember that the keys are: (1) you obtain a significant financial benefit (typically a significantly lower interest rate by at least 10%), (2) the loan is held for only a short period of time; and (3) there is no reasonably affordable alternative.

Continue to Part 2: Pros and Cons of Obtaining a TSP Loan


6 thoughts on “The TSP Loan Guide”

  1. I have been using my TSP as a sort of “savings account” for a down payment on my next house. My wife and I currently own and live in a two family house (we rent the other side). We intend on keeping it as a rental property and buying a single family house within the next year or two. I have had this plan for a couple of years so what I did was try to max out my TSP contributions – I am close to the limit, but haven’t been able to attain it yet. I will then take a residential TSP loan for a down payment once we find the house we want.

    My thought was I have the opportunity for better returns compared to savings and I would be able to put the principal back into the account. All I did was shift money that I would normally keep in a savings account for the down payment to TSP.

    I tried explaining this to people at work and their response was, “You NEVER take loans against TSP!”

    1. I think the issue with this that often gets missed is that you are putting untaxed money in the TSP but once you take it out for a residential loan, you have to repay it with taxed income and then you will pay tax again on it when you withdrawal it later in life. In effect, you get double taxed. If you’re in a 25% tax bracket for both events,, that’s a substantial penalty….or a very costly loan.

  2. This is true, but lets compare apples to apples. Any other consumer loan, with the exception of a mortgage, is being paid back with taxed income. So when I borrowed from my TSP for the short term for a real estate purchase, there were two considerations

    First, I compared rates and normalized for them for the tax implications (if it is a mortgage loan – otherwise no normalization is necessary). That is the 3.6% mortgage rate available at that time was effectively a 2.7% taxable rate in the 25% tax bracket. The comparable TSP loan rate at the time was 1.875%. This passes my first “check”. If the rate was close enough to equal I wouldn’t consider the TSP loan.

    The second consideration is the cost of “lost opportunity”. This is of course the assumption that the amount borrowed automatically “messes up” the intended allocation among the G fund and the over-time higher yielding equities. If it does this that certainly is bad! But in most cases, and certainly in mine, one has control over that. For example, if one’s intended allocation is to have say 20% in G for the duration of the time the loan is effective, you simply have to consider the principal outstanding in the loan as part of that 20% allocation. So if I borrow say $50K on a $500K TSP balance with a 20% intended G fund allocation ($100K in G), then I want to have only $50K in my G fund immediately following the loan disbursement of $50K. Then as I pay it back, each month I check my allocations and readjust if it is too out of balance (which one should check in any case unless they are fully into a life cycle fund).

    So, having done this, I don’t see how I’ve been disadvantaged. Taking the loan DOES NOT change my regular contributions (remember, this is apples to apples – if you are reducing your regular contributions to account for your loan payment, that is a foul). It does not change my allocation if I actively manage it and so the overall TSP yield would be the same. Tax implications are the same (remember, have to normalize a mortgage rate). And if I took a loan elsewhere, I’d also be making my same regular TSP contributions, but as far as the loan I’d have a bigger payment because I’d be paying out more interest to a third party (rather than less to myself within the TSP).

    There are some minor differences still. The G fund rate could go up (or down). There are a few days at disbursement where your allocation could be “off”. During payback, loan payments are allocated pro rated among the existing allocation rather than all in to the G fund. Regardless these are very minor and the second two are minimized by active and timely management.

    1. So, before taking a loan distribution, would there be any benefit to re-allocation of the TSP funds? The loan comes out proportionate to the holdings. So, would moving the entire balance to G or another low return fund right before the loan money is removed be of benefit. Then, move the money back to C fund after the loan check is cut. I assume the loan re-payment goes along with the allocation of the contributions? Thoughts??

  3. I used a TSP loan to pay off a higher interest home equity loan that I fooolishly took in addition to my traditional mortgage in an 80-15-5 home purchase (80 mortgage, 15 home equity loan, 5 down). The housing market promptly collapsed, and the home lost almost half its value, leaving me underwater and with no hope of refinancing or selling. So the TSP loan (the maximum amount paid back over 5 years) was the only way to get myself in a position to refinance the main mortgage. Despite taking a big hit for five years, it worked. We shaved about 10 years off the term of the HE loan and at a much lower interest rate and were able to refinance and lower our monthly mortgage payment. Moral for me though was to never ever pay less than 20 percent down on a home again.

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