Using Your 401(k) To Buy A House: A Guide
If you’ve been considering purchasing your first house, or just a new one, you’ve probably got a pretty good idea of what makes up your dream home. But making that dream come true requires an incredible financial commitment – and the first step is to cobble together the cash you’ll need for a down payment and closing costs.
You may be wondering whether you should consider using the money in your retirement account toward the purchase of a home. Before you decide, you need to be aware of the financial and legal considerations to take into account.
Let’s examine the pros and cons to see whether using a 401(k) to buy a house is right for you.
What Is A 401(k)?
One of the most common types of retirement plans offered by companies to their workers is a 401(k). It provides an easy way to earmark some of your salary for retirement savings as well as providing a number of tax benefits. With a traditional 401(k), you can set aside money without paying taxes right now and pay taxes when you withdraw it.
Ideally, once you’re retired, you’ll be withdrawing funds when you’re in a lower tax bracket than you’re in now. In many cases, companies also match up to part of your personal savings. This is another reason that 401(k) accounts are so popular – company matching is essentially free money.
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Can You Use Your 401(k) To Buy A House?
Yes, you can usually borrow against your 401(k) to buy a house. However, there are restrictions since 401(k)s are retirement funds set aside for you to use in your golden years. If you’ve been saving carefully, you might be wondering if it’s okay to tap into those funds right now to make a real estate investment like purchasing a home.
If you decide to go this route, it’s a good idea to make sure you’re taking a loan rather than making what could be considered an early withdrawal. You can do this by making sure you apply for a loan and receive documentation regarding the availability and terms from your plan administrator.
Since these funds have been set aside specifically for your retirement savings, if your plan allows you to withdraw money early, you’ll likely have to pay an early withdrawal penalty. Additionally, you’ll have to pay the taxes you owe in your current tax bracket.
On the other hand, if you borrow from your 401(k) and pay it back according to the terms, there wouldn’t be a tax penalty as it’s not a withdrawal. (Note that you typically cannot borrow from an IRA plan, which is another type of retirement savings plan.)
Borrowing Against Your 401(k)
So can you use your 401(k) to buy a house, and more importantly, should you? Yes, the money is yours – so you can use it for anything you want or need it for, including purchasing a home.
While you can withdraw your money from the 401(k) plan in some cases, such as financial hardship, it can be more financially advantageous to borrow instead. But you do need to be aware of some of the potential downsides. Here are some questions to ask.
Does My 401(k) Allow Me To Borrow For A Home Purchase?
If you’re seriously considering borrowing from your 401(k) to purchase a home, your employer’s HR department is your first stop. Your employer can help you determine if your 401(k) plan allows loans or put you in touch with your plan provider.
What Are The Penalties, Fees Or Taxes Involved In Borrowing From Your 401(k)?
If you borrow money from your 401(k), you’ll be required to repay the loan, typically within 5 years. Legally, the term can be longer if the money is being used toward purchasing a primary home. In addition to the principal loan amount you’ll need to pay interest. On the upside, you’ll be repaying the interest to your own account, which makes repayment a bit less onerous. However, remember these loans are paid with after-tax dollars, so you’re missing out on the tax benefits that make 401(k) accounts so attractive in the first place.
It’s crucial to keep in mind that if you use a 401(k) loan and then leave your job, the loan amount must be repaid in full. You can avoid the tax consequences of this being treated as a distribution if you roll over all or part of the outstanding balance of the loan to an IRA or other eligible retirement account by the time you next have to file your taxes. For example, if you leave your job in December, you only have until the following April 15 (or whenever Tax Day falls) to pay it back. If you’re granted an extension, these can also extend the time you have to deal with your loan. If you don’t, the money will be considered a withdrawal, which means it will be taxed at ordinary income tax rates. There are also penalties for early withdrawal before age 59.5.
What Are The Penalties, Fees And Taxes Involved In Withdrawing From Your 401(k)?
If your plan allows you to withdraw the funds rather than borrow, you won’t have to repay them, but you’ll have to pay a 10% early-withdrawal fee if you’re under 59.5 years old. That can be a big bite, especially when it’s accompanied by the taxes you must pay on the amount you withdraw. It’s also considered an early withdrawal if a loan isn’t paid back according to its terms.
What Are The Borrowing Limits For A 401(k)?
In general, you can only borrow up to 50% of your vested account balance or $50,000, whichever is less. Some plans may offer an exception if 50% of your balance is less than $10,000; you may be allowed to withdraw up to $10,000. With a withdrawal, there are no limits on the amount, assuming your plan allows early withdrawals.
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The Pros And Cons Of Using Your 401(k) For A Home Purchase
Every big financial decision you make means weighing the advantages and disadvantages. Choosing to borrow from your retirement account to invest in a home today is no exception. Let’s take a look at some of the pros and cons.
What Are The Pros?
The main pro to consider is that borrowing against your 401(k) can allow you to invest in a home or make another purchase you couldn’t otherwise afford right now. Additionally, borrowing from your 401(k) is basically borrowing from yourself versus borrowing from another lender. That means that you won’t lose as much money on interest payments as you would if you got the funds elsewhere.
What Are The Cons?
In addition to the fees and tax issues we’ve discussed, there are other cons to consider. If your employer makes matching contributions, they may stop matching for the length of the loan. Even when you’re paying yourself back, your employer won’t consider those funds a new contribution and therefore won’t match them.
Borrowing from your 401(k) might also make it more difficult to qualify for a mortgage, as it can affect your debt-to-income ratio (DTI). You’ll want to make sure you shop around to find a lender that can offer you the best option for your financial needs.
Maybe the biggest con is that you’ll lose out on the compound interest your money would have earned in the account. Since compound interest is one of the main benefits of having a 401(k), this can set you back as you build your retirement fund.
Of course, if you decide to withdraw rather than borrow from your 401(k), the main con is the giant tax hit. Since the IRS considers funds deposited into your 401(k) as earmarked for your retirement, the 10% early withdrawal penalty is considerable and a major deterrent for taking out funds before retirement.
Using Your 401(k) For A First-Time Home Purchase
If you’re still thinking of going this route, it’s important to consider all the costs that will be part of owning a home. You’ll want to make sure you're using your 401(k) to fund a purchase that isn’t difficult to maintain. Looking at your retirement account balance, it can be easy to feel as though you have more money available than you have coming in on a regular basis.
Buying a home might be the biggest purchase you make, but it’s important to remember that homeownership is not a one-time expense. In addition to your down payment, closing costs and monthly mortgage payments, being a homeowner comes with regular and sometimes unexpected expenses.
Owning a home means regular costs for maintenance, upkeep, insurance, property taxes and much more. It’s easy to get caught up in the excitement of house hunting and inadvertently make a common first-time home buyer mistake that leaves you without enough money to pay for ongoing home expenses.
Alternatives To Using Your 401(k)
The good news is that borrowing from your 401(k) is just one way to pay for your home. Let’s take a look at some of the alternative options and home loans.
Nationwide And First-Time Home Buyer Programs
There are also a wide variety of nationwide and local programs available to help first-time home buyers and low- to moderate-wage earners. There are programs to help home buyers with gathering the down payment, closing costs and getting a favorable mortgage.
State And Local Home Buyer Programs
The U.S. Department of Housing and Urban Development (HUD) maintains a list of local home buying assistance programs by state. Your lender may also be able to suggest sources of home buying help in your area.
Getting A Mortgage Without Assistance
There are also a lot of misconceptions about how much money you really need to buy a home. Many people think it’s necessary to have a 20% down payment, but that’s simply not true. You can get a conforming mortgage with a conventional lender with as little as 3% down.
Government-backed mortgages are also low down payment options. You can qualify for an FHA loan with 3.5% down. VA loans (which are limited to service members, veterans and eligible surviving spouses) and USDA loans (generally available in rural areas) often require no down payment. For qualifying home buyers, these loans can be a great option for buying a primary residence, especially for those with a history of financial hardship.
Rocket Mortgage® doesn’t offer USDA loans at this time.
Should You Use Your 401(k) To Buy A House?
The decision to borrow from your 401(k) is personal and can vary depending on the situation. As you can see, there are a variety of drawbacks and risks involved in using a 401(k) to buy a house, including:
- Missing out on new contributions while you pay yourself back
- Having to pay penalties, fees and interest (sometimes at a higher interest rate) depending on the specifics of your company’s 401(k) plan loans
- Losing out on the compounding interest your money could earn if you left it in the retirement account
- Potentially missing out on your company’s match
- Finding yourself in a bind if you change jobs and have to pay your 401(k) loan back in a lump sum
If you are planning to purchase a home, the best option for you may depend on your situation. Though each program has different qualifications, here are just a few of the alternatives to consider:
- Nationwide and first-time home buyers’ programs for low- to moderate-income home buyers
- State and local home buyer’s programs
- Government-backed mortgages like FHA, VA, and USDA loans with low to no down payment requirements
Depending on your financial situation you may have more options than you think. Be sure to explore all your options if you’re deciding whether borrowing from your 401(k) is right for you.
The Bottom Line: Purchasing A Home With Retirement Savings Isn’t The Only Option
As you can see, home buyers have many options for getting the funding they need to buy a house. Borrowing or withdrawing from your 401(k) plan is financially and legally risky. Keeping all your options in mind when deciding the best way to finance your home can help you plan for a healthy financial future.
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