Borrowing from Your 401k for a Down Payment on Your House
When you have a healthy 401(k) fund, it can be tempting to dip into your nest egg for a down payment on a new home. It can be an attractive option, but it’s important to understand the advantages and potential pitfalls before making a decision.
For first-time homebuyers the temptation to use a 401(k) for a down payment may be greatest, as saving for a down payment can be one of the biggest hurdles to buying a new home. On top of the down payment — the median down payment in the U.S. was 5% for first-time buyers in 2016, according to the National Association of Realtors — there are additional costs to consider. That includes closing costs like attorney’s fees, inspections, the appraisal and, of course, moving expenses, which can increase your out-of-pocket needs.
Before you tap into your retirement fund, you should know exactly what you’re getting yourself into first.
Borrowing from your 401(k) for a house down payment
How it works
Some, but not all, 401(k) plans allow participants to borrow from their retirement savings in the plan. Plans may set their own limits for how much participants can borrow, but loans cannot exceed 1) the greater of $10,000 or 50% of your vested account balance, or 2) $50,000, whichever is less.
Ordinarily, taking money from your 401(k) is a taxable event. Not only do you have to pay federal income taxes on the withdrawals at your ordinary income tax rate, but if you are younger than 65 (or the plan’s normal retirement age, if earlier), you may also be hit with a 10% penalty for early withdrawals. However, there are a few exceptions.
One of those exceptions occurs when you take a loan from your 401(k).
Advantages of borrowing against your 401(k)
Tyler Ozanne, a CFP in Dallas, said there are three advantages to borrowing from a 401(k) for a down payment: no underwriting qualifications, quick access to funds and no paying interest to a lender. Let’s take a look at those three advantages in detail.
You’ll almost always qualify for a 401(k) loan if you’ve got the funds
When you borrow money from a bank, credit union or another lender, you typically need to meet certain underwriting requirements, including a minimum credit score, debt-to-income ratio or a certain level of cash reserves.
With a 401(k) loan, you’re borrowing your own money, so the underwriting requirements are much less stringent. The only requirement may be that your plan might require documentation confirming your spouse approves of the loan. This approval is sometimes necessary because your spouse may be entitled to half of your retirement plan assets should you divorce.
Quick access to funds
Because you don’t have to jump through the hoops required by a typical loan application – pulling a credit report, submitting copies of bank statements and proof of income, etc. – you can typically gain access to loan proceeds much faster with a 401(k) loan.
The actual time frame for your loan will depend on your employer and the 401(k) plan administrator. Someone from HR may need to sign off on the loan, you may have to apply online or complete a paper application, the plan administrator may direct deposit funds into your bank account or mail you a check. The actual process depends on what is contained in your plan document.
No paying interest to a lender
As with most loans, you’ll pay interest on the amount borrowed, at an interest rate set by the plan administrator. But that interest isn’t paid to a lender. Since you’re borrowing your own money, the interest you pay goes back into your own retirement account. Sounds like a good deal. But is it really? In the next section, we’ll talk about the other side of this coin – what you stand to lose by borrowing from your retirement fund.
Pitfalls of using your 401(k) as a down payment on a house
Your monthly payments will eat away at your paycheck
According to IRS regulations, 401(k) loans must be repaid in “substantially equal payments that include principal and interest and are paid at least quarterly.”
Often, plans require that employees repay the loan through payroll deductions. So when you take a loan from your 401(k) for a down payment, your monthly take-home pay will be reduced by the loan payment – right around the time your monthly expenses may be increasing due to your mortgage payment and any other costs of owning a home.
Shorter repayment period
Normally, 401(k) loans must be repaid within five years. However, when the loan is taken out to purchase a home, the amortization period may be stretched out over a period longer than five years. The maximum amortization period will be outlined in the plan document.
Missed retirement savings
If you’re trying to save as much as you can for retirement, taking a 401(k) loan can be a triple whammy.
First, some plans do not allow participants to make new contributions while they have a loan outstanding and are making payments. So if you take ten years to repay your loan, that could mean an entire decade without contributing to your retirement account. Of course, you can contribute to an IRA during that time, but IRA contributions are limited to $5,500 per year ($6,500 if you’re age 50 or older). That’s much less than the 401(k) contribution limit, which is $18,500 for 2018.
Next, if your employer offers matching contributions, you’ll miss out on money during any years you can’t contribute to the plan.
And finally, the money loaned out isn’t generating investment returns. While you do earn interest on the loan by paying interest, IRS rules only require that “the interest rate […] should be similar to what a participant might expect to receive from a financial institution.” You could potentially earn a much better rate of return if the money was invested in your 401(k).
So this point gets pretty technical, but the idea of “paying yourself interest” on a 401(k) loan loses some of its appeal when you realize you’ll pay taxes twice repayments and interest.
Traditional 401(k) contributions are made with pretax dollars. So if your gross paycheck is $2,000 every two weeks and you contribute $100 from each paycheck to your 401(k), your employer will calculate your federal (and state) income tax withholding based on $1,900 of income rather than $2,000 of income. You don’t pay tax on that income now, because you’ll be taxed when you take plan distributions in retirement.
Let’s say your plan does not allow you to make 401(k) contributions while you have a loan outstanding. Now, your gross pay is still $2,000 every other week, but now your employer calculates your federal (and state) withholding based on the full $2,000 of income before deducting principal and interest on your 401(k) loan. This is called “after-tax dollars.”
The double taxation occurs when you retire and start taking plan distributions. You paid taxes on the repayment of principal and interest on your 401(k) loan when you earned it, and again in retirement.
If you want to change jobs, watch out
When you take out your 401(k) loan, you may have no intention of leaving your current employer, but things change. You might get laid off, or choose to accept a position elsewhere. When that happens, you may be required to pay the loan back in full.
If you cannot repay the loan, the employer will treat the remaining unpaid balance as a distribution and issue Form 1099-R to the IRS. That amount is considered taxable income and may be subject to the 10% early withdrawal penalty if you are under age 59½.
Recent tax reform did give 401(k) borrowers a little more time to repay loans after they leave the company and avoid getting hit with a taxable distribution. Prior to the Tax Cuts and Jobs Act, the employee had only 60 days to either pay the remaining balance in full or roll it over to another eligible retirement plan. As of Jan. 1, 2018, employees have until the due date for filing their tax return for that year, including extensions, to repay or roll over the loan.
Other ways to cover a down payment
Considering the potential pitfalls of borrowing from your 401(k), you might want to find an alternative to coming up with a down payment on a home.
Ozanne recommends the following alternatives:
- Wait until you can afford to purchase a home without jeopardizing your retirement savings.
- Make a smaller down payment. You might have to pay private mortgage insurance (PMI) if you put less than 20% down, but that could work out to be less than the missed investment opportunity in your 401(k).
- Get a loan from family or friends.
- Consider whether you have access to other savings, such as a Roth IRA, that can be tapped without penalty.
There are many options for purchasing a home with a low or no down payment, so often there’s little need to put your retirement at risk by borrowing from a 401(k) to purchase a home. Saving up for a down payment, closing costs and other expenses of buying and owning a home can take quite a while, but if you can’t afford to save for those costs, taking a 401(k) loan to buy a house could make your financial situation worse.