Borrowing From Your 401(k) to Buy a House
Buying a home is an exciting milestone but it's often one that 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 typical home down payment was 11 percent of the purchase price in 2016. That would come to $22,000 for a $200,000 home. Closing costs, which includes administrative fees and other costs to finalize your mortgage loan, add another 2 percent to 5 percent of the home's purchase price onto the total.
While the seller may pay some of the closing fees, you may still be responsible for assuming part of the cost. As you plan your home purchase, you may be wondering if you can borrow from a 401(k) a house if you don't have liquid cash savings for the down payment or closing costs. The short answer is yes, but the more important question is, should you?
Borrow From a 401(k) for a House: Getting a 401(k) Loan
If you'd like to borrow from 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 interest back to yourself and the rate may be low but this isn't free money that you're accessing. Something else to note about 401(k) loans is that not all plans permit them. If your plan does, you must be aware of how much you can borrow. The Internal Revenue Services limits 401(k) loans to 50 percent 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. If you've already taken a loan, those monthly payments are included in your debt-to-income ratio, which is how much of your income goes toward debt repayment each month. Ideally, your debt-to-income ratio should be 43 percent or less to qualify for a mortgage.
Making a 401(k) Withdrawal to Buy a Home
Compared to a loan, a withdrawal from your 401(k) 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, the way you would be with a loan. It's not as easy as it seems, however, to borrow from a 401(k) for a house using a withdrawal.
The first thing to understand is that your employer may not even allow withdrawals from your plan prior to age 59 1/2. 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.
But, you may be able to withdraw from a 401(k) plan that you've left behind at a previous employer. This, however, is where things can get tricky.
If you're under age 59 1/2 and you decide to cash out an old 401(k), you'll owe both a 10 percent early withdrawal penalty on the amount withdrawn, along with ordinary income tax. Twenty percent of the amount distributed is automatically withheld for federal taxes, meaning that if you withdraw $40,000, $8,000 would be set aside for taxes.
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, 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 bite associated with an early withdrawal, a 401(k) loan could be the more attractive option if the interest you'll repay is less than what you'll owe in taxes. 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 is insurance that protects the lender and it's required if you're putting less than 20 percent down. You pay an upfront premium for coverage, along with a monthly premium, which is added to your mortgage payment. Private mortgage insurance can be eliminated when you reach 20 percent equity in the home but it can add to the cost of home ownership 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 which 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 you in your efforts to buy a home, you may consider asking them to gift you 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 you're getting. The most important thing to remember with down payment gifts is that they must be thoroughly documented. Otherwise, the lender may now 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 percent early withdrawal penalty. Beware, however, 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're not having to come up with a huge sum of cash out of pocket. However, the impact to your retirement and the potential to owe more in taxes must be weighed carefully before you commit.