See what mortgage you qualify for
A major barrier to homeownership is coming up with enough cash for a down payment. Though prospective buyers can potentially secure a loan with as little as 3% down for a conventional mortgage, 20% down is ideal to avoid private mortgage insurance (PMI).
If you’re saving up for a down payment, you may have wondered if your 401(k) could be a potential source to borrow funds.
Borrowing against your 401(k) to buy a house is a valid option, but it’s not necessarily the best one. Let’s break down how a 401(k) works, the downsides of borrowing before retirement age and alternative sources for a home purchase down payment.
How Does a 401(k) Work?
Anyone who’s been in the workforce has likely heard the term 401(k) – an employer-sponsored, tax-deferred retirement account. That means you can contribute money from your paycheck before taxes are taken out and invest the money for retirement. Your employer may also match your contributions up to a certain percentage.
This money is usually invested in a mutual fund or other growth fund and can grow over time. You’ll only pay taxes once you start withdrawing the funds during retirement.
The earliest you can start withdrawing from your 401(k) without an early withdrawal penalty is age 59 ½. The only exception is if you’ve left or lost your job and are 55 or older.
These regulations may seem strict, but they’re in place to encourage people to save an adequate retirement fund. Early withdrawals can amount to a significant loss of money over time from tax penalties and lost gains from compound interest.
How To Use a 401(k) To Buy a House
Since retirement accounts are meant to be a long-term way to invest for the future, it’s not recommended to borrow money from them. However, if you’re still interested in utilizing funds from your 401(k) to purchase a home, there are two ways to do so:
Take out a 401(k) loan
Compared to a withdrawal, a 401(k) loan is the better option because you’ll avoid the 10% early withdrawal penalty. Also, the money you borrow won’t be subject to income tax.
The maximum amount you can borrow from the retirement account is 50% of your vested account balance or $50,000, whichever amount is less. There’s one exception to this limit, if your vested account balance is less than $10,000. In this case, up to $10,000 can be borrowed. However, plans aren’t required to offer this exception.
The repayment period is determined by the plan administrator, but typically the maximum loan term is five years. An exception to this rule is using the loan to purchase a primary residence. The interest rate on the loan is usually a point or two above the current prime rate.
Another benefit to a 401(k) loan is that it won’t count toward your debt-to-income (DTI) ratio, which is an important factor during the mortgage application process. Consequently, the loan won’t negatively impact your credit score or be counted by any credit bureaus.
Make a 401(k) withdrawal
You may opt to withdraw money from your 401(k) without having to pay it back, but in many situations, you’ll have to pay a 10% early-withdrawal fee and income tax. This makes a withdrawal a much less appealing option to most people than a loan.
However, if you’re taking a withdrawal in order to cover expenses related to purchasing a primary residence, the penalties can be waived.
Before choosing a loan or withdrawal from your retirement account, you should always consult a CPA that can advise you on exact details of how these actions may result in fees and penalties.
Is It Wise To Use Your 401(k) To Buy a House?
While it’s possible to use your 401(k) to buy a house, it’s far from ideal. The loss of investment income over time may outweigh the short-term benefits of having more money for a down payment. There’s no guarantee your home will appreciate enough to justify the loss of retirement funds.
Borrowing as little as $10,000 can have a huge impact on what you have available for retirement. For example, $10,000 with a 7% annualized rate of return would become just over $76,000 in 30 years. For that reason, most experts would agree funds in your retirement account should stay there until you retire.
Are There Alternatives to Borrowing Against Your 401(k)?
Before you decide on a 401(k) loan or withdrawal, consider your other options. There are several alternatives to help you put down enough money on a new home. These options can include:
Borrow from your IRA
Much like a 401(k) plan through an employer, there are two main types of individual retirement plans, or IRAs.
A traditional IRA has special provisions for first-time home buyers. According to the IRS, you qualify for that label if you haven’t owned a primary residence within the past 2 years.
The IRS allows a first-time homebuyer to withdraw up to $10,000 from an IRA without having to pay the 10% tax penalty – you’ll still have to pay income tax. The funds can be used for any costs associated with buying, building or rebuilding a home. It also must be used within 120 days of receiving it.
Another thing to note is that if you’re married, your spouse can also withdraw $10,000 to contribute to the same home purchase.
The other type of IRA, a Roth IRA, is a retirement savings account that’s contributed to on an after-tax basis. That means you can withdraw from it tax-free during retirement. Roth IRAs also have a provision that allows an early withdrawal of up to $10,000 penalty-free and tax-free for a first-time home purchase.
Look for low down payment loans
Before tapping into your retirement account, it’s worth exploring different types of low down payment loan options available through various lenders. Working with a loan officer, you can check your eligibility for a wide range of government-backed and conventional home loans, including:
A Federal Housing Administration (FHA) loan is better for individuals with lower credit scores and less available cash to put down on a home. Only a 3.5% down payment is required.
Home loan programs through the U.S. Department of Agriculture (USDA) provide affordable loans to low- and moderate-income households in eligible rural areas. Those who qualify can get a home loan with no money down.
HomeReady® and Home Possible®
Loan programs from Fannie Mae and Freddie Mac – like HomeReady® and Home Possible® – are conventional loan programs for borrowers with limited cash for a down payment. If you have a credit score of at least 620 and make less than 80% of the area’s median income, you may be able to secure a loan for as little as 3% down.
U.S. Department of Veterans Affairs (VA) loans offer veterans and service members home loans with more flexible terms, lower interest rates and no down payment.
Take advantage of home buyer assistance programs
In addition to different types of mortgage loan programs, there are also first-time home buyer grants. These programs are often state-sponsored and include tax-incentives, special loans and down payment assistance programs. Ask your lender about any special programs you might qualify for.
Ask for gifts and support from family and friends
While this option may not be possible for everyone, if you’re in a situation where you can get financial support from family or close friends, it’s worth considering. Starting in 2023, an individual can gift someone up to $17,000 without having to pay a gift tax.
Of course, there can be complications with accepting money from family or friends, whether it’s a tax-free gift or not. Make sure to have an honest conversation about the implications and expectations of this type of situation.
Think Before You 401(k) Your Home
Buying a house can be a challenging process, especially as a first-time buyer. Coming up with adequate funds for your down payment can be one of the biggest hurdles. While borrowing against your 401(k) is an option, it’s not the best idea. There are better alternatives that will leave your retirement money where it should be!
Take the first step toward buying a home.
Get approved. See what you qualify for. Start house hunting.
Internal Revenue Service. “Retirement Topics – Plan Loans.” Retrieved November 2022 from https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-loans
Internal Revenue Service. “Publication 590-B (2021), Distributions from Individual Retirement Arrangements (IRAs).” Retrieved November 2022 from https://www.irs.gov/publications/p590b#en_US_2021_publink100090128
Internal Revenue Service. “Topic No. 557 Additional Tax on Early Distributions From Traditional and Roth IRAs.” Retrieved November 2022 from https://www.irs.gov/taxtopics/tc557
U.S. Department of Housing and Urban Development. “Basic Home Mortgage Loan 203(B).” Retrieved November 2022 from https://www.hud.gov/program_offices/housing/sfh/ins/sfh203b
Fanne Mae. “HomeReady FAQs.” Retrieved November 2022 from https://singlefamily.fanniemae.com/media/8316/display
Internal Revenue Service. “What’s New – Estate and Gift Tax.” Retrieved November 2022 from https://www.irs.gov/businesses/small-businesses-self-employed/whats-new-estate-and-gift-tax