If you’re purchasing a home, then you’re going to need a down payment.
Many home buyers are not aware that they can withdraw from their 401k to use for the down payment.
Obviously, there are some drawbacks to doing so.
In this article, we’re going to take a more in-depth look into the pros and cons of using funds from your 401k to buy a house.
What is a 401(k) Loan?
You’re allowed to take out a loan from your 401k or IRA. You will be borrowing money from yourself and then paying yourself back with interest.
The 401k loan will be required to paid back, usually automatically deducted from your paychecks.
A 401(k) loan has a tax advantage over a typical early withdrawal from your 401k without paying it back.
When you withdraw early, you will be charged a 10% tax penalty.
If you get a loan and promise to repay the amount, then you are not charged a penalty tax.
As with any loan, interest accumulates on the amount borrowed. However, since it is your money, the interest is paid back to yourself, added to your 401k balance, and not paid to a lender.
You will need to talk to your plan administrator about a hardship withdrawal to purchase a home.
How much can I borrow?
- $50,000, or
- 50% of your 401(k) account balance
- If the account balance is less than $10,000, you can borrow up to $10,000 up to your account balance.
Pros of Borrowing from your 401k
- Eliminate PMI if putting down more than 20%
- Able to buy a home quicker by accessing your money
- Your 401k balance will be repaid with interest
- No tax penalty if a promise to repay is made
When Using Your 401K to Buy a House is a Good Idea
While most financial advisors will strongly advise you not to use your retirement funds for your down payment on a house. However, there are certain situations where it could save you a lot of money.
Avoiding PMI with a 20% down payment
Let’s say you’re buying a $300,000 home with a $30,000 down payment with a 5% rate for 30 years.
You will be required to carry private mortgage insurance because you’re putting less than 20% down. Your monthly payment will be $1,449.42, including insurance, property taxes, and PMI of $112.50 monthly.
If you can borrow another $30,000 from your 401k account, you will have a $60,000 down payment, 20% of the purchase price. You avoid PMI and have a monthly mortgage payment of $1,288.37, a savings of $161.05 per month over 30 years, saving you $57,978 over the life of the loan.
Becoming a First Time Home Owner
Buying a home is cheaper than renting in the long run. Not only can you save money each month, but you will also be building equity with each payment.
If you’re like most other first-time homebuyers, the biggest hurdle to buying a house is the down payment.
If you have a healthy 401k balance and purchasing a home will get you a monthly payment lower than your rent, then it may be wise to use your retirement account for the down payment.
If you can Pay Back to Loan in Less than a Year
If you do have to use your retirement account for the down payment, then it is best if you can repay the loan as quickly as possible.
Maybe you are expecting a big bonus, a raise, or have something to sell like a car. And you expect to be able to pay back the amount you borrow; then the risk is significantly reduced.
Cons of Borrowing from your 401k
- Mortgage and 401k loan payment will give you a more substantial total monthly payment until the 401k loan is paid off
- You may not be able to contribute to 401k until the loan is paid back
- May lose out on matched contributions from your employer
- If you leave the company, the loan must be repaid within 60 days to avoid an early withdrawal penalty.
When Borrowing from Your 401k is a Bad Idea
Borrowing from your retirement plan for any reason is a risky proposition. There are several pitfalls to borrowing from your 401k or IRA account to buy a house.
If your debt-to-income ratio is high and you’re already cutting your monthly budget pretty thin by getting a mortgage, then having a separate loan payment may make using your 401k to buy a house a terrible idea.
And even if you have plenty of money left over after paying your bills, tapping into your 401k should still be a last resort.
Your Retirement could be Harmed in the Long-Term
When borrowing from your 401k, you may not be able to contribute additional funds to your account while repaying the loan.
If your employer offers any type of retirement contribution matches, then you will not be able to take full advantage of this.
When looking at your retirement savings in the long-term, the total amount will be less than it could because you’re not able to contribute for years.
When you withdraw funds from your retirement plan, you are subject to a 10% income tax penalty. The fund that money is in may also have an early-withdrawal fee.
The tax penalty is waived if you are getting a 401k loan and are repaying the amount borrowed.
However, if you leave your current employer for any reason, you may have to repay any loans within 60 days. If you’re unable to repay within the window of time, then you could face the 10% tax penalty.
Low and No Down Payment Mortgages
Instead of getting a loan for your down payment, you can look into some of the Government-backed loans that offer low and no down payment mortgages.
FHA Loans – FHA home loans require a low 3.5% down payment, making them a prevalent option. With a down payment this low, you may not need to use your retirement account to afford the down payment.
VA Loans – If you’re a Veteran, you could qualify for a VA home loan with no down payment. This is one of the greatest benefits offered to Vets in our Country. Not only do VA loans provide 100% financing, but no mortgage insurance is required.
USDA Loans – The U.S. Department of Agriculture guarantees loans for low-to-median income families in rural areas of the Country. The USDA finances 100% of the purchase price for eligible borrowers.
Conventional 97 Loan – This type of conventional loan was created by Fannie Mae to compete with the low down payment Government-backed loans. As the name suggests, a conventional 97 loan offers a 3% down payment, allowing you to finance 97% of the purchase price.