Buying a home is an exciting milestone, but it often requires a significant financial investment. While it's important to calculate how much home you can afford and how your monthly mortgage payments will affect your budget, there are other costs to consider.
Two of the most important are your down payment and closing costs. According to the National Association of Realtors, the median home down payment was 12% of the purchase price in 2019. That would come to $24,000 for a $200,000 home. Closing costs, which include administrative fees and other costs to finalize your mortgage loan, add another 2% to 7% of the home's purchase price.
While the seller may pay some of the closing fees, you're still responsible for assuming some of the costs. You can borrow from a 401(k) to buy a house if you don't have liquid cash savings for the down payment or closing costs. Here's what to consider before you make that move.
- If you don't have the liquid cash for a down payment or closing costs for your new home, you could consider borrowing from your 401(k).
- When borrowing from your 401(k), you can either take out a loan or make a withdrawal, and each option has potential benefits and drawbacks.
- The impact on your retirement and the potential of owing more in taxes must be weighed carefully before you commit.
Getting a 401(k) Loan for a Home
If you'd like to use your 401(k) to cover your down payment or closing costs, there are two ways to do it: a 401(k) loan or a withdrawal. It's important to understand the distinction between the two and the financial implications of each option.
When you take a loan from your 401(k), it must be repaid with interest. Granted, you're repaying the loan back to yourself and the interest rate may be low, but it's not free money. Something else to note about 401(k) loans is that not all plans permit them. If your plan does, be aware of how much you can borrow. The IRS limits 401(k) loans to either the greater of $10,000 or 50% of your vested account balance, or $50,000, whichever is less. For example, if your account balance is $50,000, the maximum amount you'd be able to borrow is $25,000, assuming you're fully vested.
In terms of repayment, a 401(k) loan must be repaid within five years. Your payments must be made at least quarterly and include both principal and interest. One important caveat to note: loan payments are not treated as contributions to your plan. In fact, your employer may opt to temporarily suspend any new contributions to the plan until the loan has been repaid. That's significant because 401(k) contributions lower your taxable income. If you're not making any new contributions during your loan repayment period, that could push your tax liability higher in the interim.
Taking a loan from your plan could also affect your ability to qualify for a mortgage. Loan payments are included in your debt-to-income ratio, which is how much of your income goes toward debt repayment each month, and lenders want your ratio to be 43% or less.
Making a 401(k) Withdrawal for a Home
Compared to a loan, a withdrawal seems like a much more straightforward way to get the money you need to buy a home. The money doesn't have to be repaid and you're not limited in the amount you can withdraw, which is the case with a 401(k) loan. Withdrawing from a 401(k) isn't as easy as it seems, though.
The first thing to understand is that your employer may not even allow withdrawals from your 401(k) plan due to age. If they do allow employees to tap 401(k) funds early, you may have to prove that you're experiencing a financial hardship before they'll allow a withdrawal. Under the IRS rules, consumer purchases generally don't fit the hardship guidelines.
You may be able to withdraw funds from a 401(k) plan that you've left behind at a previous employer and haven't rolled over to your new 401(k). This, however, is where things can get tricky.
If you're under age 59 1/2 and decide to cash out an old 401(k), you'll owe both a 10% early withdrawal penalty on the amount withdrawn and ordinary income tax. Your plan custodian will withhold 20% of the amount withdrawn for taxes. If you withdraw $40,000, $8,000 would be set aside for taxes upfront, and you'd still owe another $4,000 as an early-withdrawal penalty.
With a 401(k) loan, the early-withdrawal penalty and income tax would not apply, with one very important exception. If you leave your job before paying off your loan, any remaining loan balance would become payable in full. If you don't repay what you owe, the entire amount is treated as a taxable distribution. In that scenario, you'd pay income taxes and the penalty if you're under age 59 1/2.
Does a 401(k) Loan or Withdrawal Make More Sense?
When you consider the potential tax consequences associated with an early withdrawal, a 401(k) loan may seem more attractive. Of course, there's one drawback with both options: you're diminishing your retirement savings.
With a 401(k) loan, you'd have the ability to replace that money over time. If you're cashing out an old 401(k), however, there's no way to put that money back. In both cases, you're missing out on the power of compound interest to grow your retirement wealth over time.
One upside of deciding to borrow from a 401(k) for a house—whether you take a loan or make a withdrawal—is that it may allow you to avoid paying private mortgage insurance if you offer the lender a large enough down payment. Private mortgage insurance protects the lender, and it's typically required if you're putting less than 20% down on a conventional mortgage. Private mortgage insurance can be eliminated when you reach 20% equity in the home, but it can add to the cost of homeownership in the early years of your mortgage.
Alternatives to Borrowing From Your 401(k)
Before you borrow from a 401(k) to buy a home, consider whether there are other options available. For example:
- Down payment assistance programs: Down payment assistance programs are designed to help eligible buyers with down payment and closing costs. Some programs offer grants to qualified buyers that don't have to be repaid. Others offer matching savings programs, similar to a 401(k), that match every dollar you save towards your down payment, up to a certain amount.
- Down payment gifts: If you have family members who want to support your efforts to buy a home, consider asking them to gift money for a down payment. The amount of money that can be gifted and the amount you have to put towards the down payment out of your own funds may vary based on the type of mortgage. The most important thing to remember with down payment gifts is that they must be thoroughly documented. Otherwise, the lender might not allow you to use those funds for your down payment.
- IRA withdrawal: If you have an IRA, you can withdraw up to $10,000 from your account towards a down payment on a home without incurring the 10% early-withdrawal penalty. Be aware that if you're withdrawing from a traditional IRA, you'll still owe income tax on the amount you withdraw.
Borrowing from a 401(k) does have certain benefits, chiefly that you don't have to come up with a huge sum of cash out of pocket. However, the impact on your retirement and the potential to owe more in taxes must be weighed carefully before you commit.
Frequently Asked Questions (FAQs)
What happens if you default on a 401(k) loan?
When you default on a 401(k) loan, it's usually treated as an early withdrawal. Each plan can set its own rules, so you should check with your 401(k) company to see whether it handles the situation differently. When the remaining loan balance is reclassified as a "deemed distribution," you will owe all the penalty and income taxes you would owe on any early 401(k) withdrawal.
Who gets the interest payments from a 401(k) loan?
You get the interest you pay on the 401(k) loans, since you are essentially lending money to yourself. Keep in mind that the interest payments are made with after-tax dollars. That's a downside to 401(k) loans, because those after-tax dollars will be taxed again when they're taken out as a 401(k) withdrawal in retirement.