Perhaps the toughest thing for many aspiring homeowners is putting enough cash aside to save for a down payment. When that dream home hits the market at just the right price and your savings aren't enough, it can be tempting to eye a 401(k) as a quick source of cash.
It is possible to borrow money from a 401(k) to finance the down payment on a home, but it's rarely the best option. While you get the money you need for the purchase of a home, it comes at the expense of your retirement savings. Here are a few things to know about using your 401(k) to cover the down payment on a house as well as some more responsible alternatives.
The drawbacks of borrowing from your 401(k)
You're legally allowed to withdraw the lesser of $50,000 or 50% of your 401(k) balance for a loan. Normally 401(k) loans have a maximum five-year repayment period, but this deadline is extended if the loan goes toward the purchase of a primary residence. That said, you will still have to make regular monthly payments and pay back the balance that you owe with interest.
The obvious problem with this is that when you withdraw money from your 401(k), it is no longer able to accrue interest. When you take out a 401(k) loan, you must pay back the principal amount plus interest. The interest rate is usually the prime rate -- currently 5.25% -- plus 1%. So in this example, you would pay 6.25% interest on the borrowed amount. This may not seem like a bad deal, but it's possible that, had you left the money in your 401(k), it would have accrued even more in interest during that period.
Consider: If you borrow $20,000 from your 401(k) with a 30-year loan term and a 6.25% interest rate, you'll have $34,216 less by the end of those 30 years than if you had left it in your 401(k), assuming an 8% interest rate.
There are other problems with 401(k) loans as well. If you fail to pay back what you borrow, the outstanding balance will be considered a distribution, becoming subject to income tax. Plus, if you're younger than 59 1/2, it is subject to an additional 10% early withdrawal penalty.
It's also worth noting that 401(k) loans come due if you leave your job, are laid off, or fired. If that happens, you'll have to come up with the funds to cover the remaining balance within two to three months, or else it will be considered a distribution subject to taxes.
Alternatives to taking out a 401(k) loan for a home
Choosing a more affordable home that requires a lower down payment is obviously an option. Further, you could wait to purchase the home until you can save up for the down payment, although the house you set your sights on may not still be on the market. If neither of these options are palatable to you, it's time to consider alternative financing, of which there is plenty.
Perhaps the easiest is to see if you can get a Federal Housing Administration (FHA) loan or a U.S. Department of Agriculture (USDA) loan. FHA loans require only 3.5% down, and USDA loans don't require any money down. However, you'll have to pay private mortgage insurance (PMI) until you reach 20% equity in your home. Veterans Affairs (VA) loans are also worth considering if you are serving or have served in the military.
If you are determined to buy the home now, you may be better off borrowing from your IRA, if you have one, than your 401(k). First-time home buyers can borrow up to $10,000 without paying an early distribution penalty, although the amount will be added to your income tax this year, unless it comes from a Roth account which is post-tax. But while the consequences might be slightly less severe than borrowing from a 401(k), you're still losing out on the compound interest that would have been earned from leaving that money in the IRA.
Owning a home can be a wonderful thing, but it isn't worth risking your retirement security. Consider all your options before taking out a 401(k) loan for your home's down payment, and make sure you understand the repayment terms so you don't run into unexpected surprises down the road of home ownership.