If you’ve been thinking about buying a home, you’re likely dreaming of that ensuite bathroom, fenced yard, kitchen for entertaining, all the bells and whistles. But then, that dream might come to an abrupt halt as you realize the cold truth that you are about to make an incredible financial commitment – and the first step will be coming up with quite a pile of money to give your lender for the down payment.
But, hey, you may be thinking ... you already have a pile of money just sitting there waiting, right in your retirement account. It might make you start wondering if you could (and should) use your 401(k) to buy a house. Let’s examine the pros and cons and see whether that’s a good financial choice.
Can You Use Your 401(k) To Buy A House?
Retirement accounts are just that: money that’s being set aside for you to use in your golden years. And if you've been carefully saving, you might be wondering if it’s OK to tap those funds to use for something right now, like a home purchase, given that it’s an investment in its own right.
One of the most common type of retirement plans is the 401(k), which is often offered by companies to their workers. It provides an easy way to earmark some of your salary for retirement savings, along with the tax benefits that a 401(k) brings. You’ll be setting aside money without paying taxes right now and then will pay the taxes when you withdraw it, which ideally will be when you’ re in a lower tax bracket than you are in now. In many cases, companies also match up to part of your personal savings, which is another reason that 401(k) accounts are so popular, since that’s essentially “free money.”
But those funds have been set aside specifically for your retirement savings, which means that if your plan allows you to withdraw it earlier, you’ll pay a penalty, along with the taxes you owe given your current tax bracket. There’s usually the potential to borrow from it, though, which may be a better option. (Note that you typically cannot borrow from an IRA plan, which is another type of retirement savings plan.)
So, while you can use your 401(k) for first time home purchase in most cases; the question is whether you should.
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 technically yours so you can use it for anything you want or need it for, including as a 401(k) first-time home buyer.
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?
That, of course, is the first thing to find out, so check with your employer or HR department to see if your 401(k) plan allows loans.
What Are The Penalties, Fees, Or Taxes Involved In Borrowing From Your 401(k)?
If you borrow the money, you’ll be required to repay the loan, typically within 5 years. You’ll be paying interest while you do it, which is generally at the interest rate of 2 points over “prime rate.” But the interest will be used to pay yourself, which makes it 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.
And note that if you use a 401(k) loan and then leave your job, the full amount must be repaid before you file taxes for the year in which you left your job (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 don’t, it's considered a withdrawal, which means it will be taxed at ordinary income tax rates.
What Are The Penalties, Fees, Or Taxes Involved In Withdrawing From Your 401(k)?
If your plan allows you to withdraw the funds, rather than borrowing, you won’t have to pay them back, but you’ll experience a 10% early-withdrawal fee if you are under the age of 59 ½. That can be a big bite, especially when it’s accompanied by the taxes you must pay on the amount owed.
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 your balance is less than $10,000; you may be allowed to withdraw the entire amount. With a withdrawal, there are no limits on the amount, assuming your plan allows you to do so.
What Are The Pros?
Besides allowing you to make a purchase you might otherwise not be able to make, borrowing from your 401(k) is basically borrowing from yourself, rather than another lender. That means that you might not be losing as much money on interest payments as you would if you got the funds via another means.
What Are The Cons?
Besides the fees, your employer will likely stop their side of the match, if they were making one. Even when you’re paying yourself back, they won’t consider those funds a new “contribution” and therefore won’t match it. It also might make it more difficult to qualify for a mortgage, as it can affect your debt-to-income ratio, but be sure to shop around to find a lender who will offer you the best program that fits your financial needs. And of course, you’ll lose out on the compound interest your money would have been earning if you’d left it in the account.
Of course, if you decide to withdraw rather than borrow from your 401(k), the main con is the giant tax hit you will suffer.
Using Your 401(k) For A First-Time Home Purchase
If you’re still thinking that you might want to go this route, it’s important to consider all the costs that will be part of owning a home, to make sure that you’re not using your 401(k) as a way to fund a purchase that might be difficult to maintain. Looking at your retirement account balance might make you feel as though you have more money than you actually have coming in on a regular basis.
Buying a home might be the biggest purchase you make, but it’s important to remember that it’s not a one-time expense. 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 first-time home buyer mistake that leaves you without sufficient funds to pay the ongoing expenses a home requires.
Should You Use Your 401(k) To Buy A House?
As you can see, there are a variety of drawbacks and risks involved in using a 401(k) to buy a house. These include:
- Missing out on making 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)
- Losing out on the compounding interest your money could earn if you left it in the retirement account
- Missing out on your company’s match
- Finding yourself in a bind if you change jobs and have to pay your 401(k) back in a lump sum
As you can see, there are definitely reasons why you might want to avoid this approach to home buying.
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. Here are some alternatives that might be less risky.
The Coronavirus Aid, Relief and Economic Security (CARES) Act includes a number of provisions designed to stimulate the economy and help those dealing with economic strain due to COVID-19. One of its elements includes the ability to take a penalty-free withdrawal from your 401(k) of up to $100,000, or 100% of your vested balance, if you have been adversely affected. That means you will not be subject to the early withdrawal penalty even if you’re not yet 59 ½, says the IRS. If you do withdraw money, one-third of the total will be included as income in your taxes for each of the next 3 years to spread out the tax implications. you can pay it back over 3 years without having it recognized as income for tax purposes. (Note that the withdrawal needs to take place by the end of 2020 to qualify for this special dispensation, and your employer can choose whether to comply.) Be sure to talk to a financial advisor about whether this is a wise strategy for your specific situation.
Down Payment Assistance Programs
You also should look into down payment assistance programs. Talk to your mortgage lender about which ones you might qualify for. Typical options include:
- Grants: These are funds you don’t have to pay back. These are offered by a variety of nonprofit and community organizations and vary according to where you live and your financial situation. They also could be available to various ethnic groups or to members of the military.
- Forgivable loans: As long as you meet the conditions of the loan, such as living in your house for a certain amount of time, these might not need to be paid back at all. As a bonus, many are interest-free.
- Deferred-payment loans: These types of loans don’t require you to start your repayment for several years, when presumably your financial situation has improved. Just make sure that they are zero interest (or at least low interest) so that you don’t accrue giant payments.
- Low-interest loans: Often these are loans that you can get from your employer through a special down payment assistance program they offer. Make sure you fully understand the terms before committing, especially if you might be considering a job change.
These are just a few of the programs you might qualify for. Be sure to talk to your lender about options so that you take advantage of whatever is available to you.
First-Time Home Buyer Loans And Programs
In addition to the aid mentioned above, there are several first-time home buyer loans and programs for which you might qualify. A few examples are:
- FHA loans: These are ideal for someone with questionable credit who hasn’t amassed a large down payment.
- VA loans: These loans, which include a no down payment feature, are available to those with a military connection.
- USDA loans: These are available for people who are buying homes in “rural” areas, and you might be surprised what qualifies. Make sure to check out this map to see the areas that are included in case you might be able to take advantage of this program.
- Other state and regional loans: Make sure to talk to your lender about anything that might be available in your area to encourage home ownership.
Heading Toward Homeownership: Can You Use Your 401(k) To Buy A House?
As you can see, home buyers have many options for getting the funding they need, including borrowing or withdrawing from their 401(k) plan.
But remember that you could be missing out on crucial retirement savings during the repayment period and could also owe penalties should something go wrong. While it can be tempting to borrow or withdraw money that’s just sitting in your 401(k), it might not be the best choice. Make sure to discuss your options with your financial advisor and lender to ensure you’re making the decision that’s best for your financial future.
Have more questions about mortgage loan programs and options? Contact a mortgage expert today.