When you’re searching for a home, coming up with a large enough down payment can be challenging. Many home buyers are not aware that they are able to withdraw from their 401k to use for the down payment.
Here are the pros and cons of using funds from your 401k to buy a house.
What is a 401(k) Loan?
A 401k is a retirement savings plan sponsored by an employer. It allows you to save and invest a piece of your paycheck before taxes are taken out. So naturally, a 401k loan is when you borrow money you’ve saved up in your retirement account with the intent to pay yourself back.
But even though you’re lending money to yourself, it’s still a loan that’s charging interest. However, since it is your money, the interest is paid back to yourself, added to your 401k balance, and not paid to a lender.
If you were to take an early withdrawal from your 401k without paying it back, you would be charged a 10% tax penalty. However, the great advantage to a 401k loan is if you promise to repay it, you won’t be charged this penalty.
How Much Can I Borrow?
You may borrow up to $50,000, or 50% of your 401k account balance. However, you first need to check with your plan administrator to see if it’s allowed. Not all companies that maintain 401k savings plans offer a borrowing option.
When Using Your 401(k) is a Good Idea
The most common reasons someone would use a 401(k) loan is to help with the down payment and avoiding mortgage insurance costs.
Some homeowners, especially first-time home buyers, may not have the money to make the down payment required by conventional and FHA loans. Taking a home loan from your retirement plan can make it possible for you to have the down payment money you need to buy a home.
Some other home buyers want to avoid paying PMI entirely, which is usually required if the down payment is less than 20%. Taking a loan from your retirement plan in this scenario can help you save hundreds of dollars per month on mortgage insurance.
Pros of Borrowing from your 401(k)
- Eliminate PMI if putting down more than 20%
- Able to buy a home quicker by accessing your money
- You’re 401k balance will be repaid with interest
- No tax penalty if a promise to repay is made
The Pitfalls of a 401(k)
When your 401k loan is outstanding, you usually cannot make contributions to your existing retirement plan. This means that you could forgo up to 5 years of retirement fund contributions, which could have a significant impact on your future. In addition, if your employer matches the 401k, you will be missing out on those too.
The other major risk to consider is unforeseen circumstances. If you leave your company after borrowing against your 401k, you will only have up to 60 days to repay the entire balance in full. If you cannot make that payment, you will have to pay a 10% tax penalty.
Cons of Borrowing from your 401(k)
- Mortgage and 401k loan payment will give you a larger total monthly payment until the 401k loan is paid off
- You miss out on investment earnings and 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 a penalty.