Should You Borrow From Your 401(k) to Make a Home Down Payment?
by Christy Bieber | Updated July 19, 2021 - First published on June 17, 2021
You may regret making the choice to raid your retirement funds.
When you're trying to buy a home, it's best to make a 20% down payment. Doing so allows you to avoid having to buy private mortgage insurance (PMI). PMI ensures lenders don't end up with out-of-pocket losses if they have to foreclose. Unfortunately you cover the expenses of PMI, although it provides you with no personal protection.
A 20% down payment is also useful because it:
- Makes it easier to get approved for a home loan
- Allows you to borrow less
- Saves you money on interest over time
- Makes it less likely you'll end up owing more than your home is worth
Unfortunately, coming up with 20% down can be difficult for many home buyers. And, in fact, even finding the money for a smaller down payment can be a challenge if you're in an expensive market.
If you decide now is a good time to buy a home but struggle to come up with the cash to make a down payment, you may be tempted to borrow against your 401(k). After all, if you have a lot of money sitting in this account, it may seem like an attractive source of funds that could solve your down payment issues.
But, before you decide to move forward with a 401(k) loan, it's essential to consider both the pros and cons of this financial move.
Benefits of using a 401(k) loan to make a home down payment
There are some definite advantages to accessing 401(k) funds to cover the down payment costs for a home purchase.
- You'll be paying interest to yourself. That means you won't be making a creditor richer as you would if you used a second mortgage or took out a larger home loan to cover your down payment costs.
- Loan approval is easy. Provided you have the money in your 401(k), you should be able to borrow against it regardless of your credit or other financial credentials -- as long as your workplace plan allows loans.
- You can usually access the money quickly and easily. It's often a matter of filling out a few simple forms and you can get the money very quickly, although the exact timeframe will depend on your plan.
- You may be able to get a better deal on your mortgage. Making a larger down payment, made possible by a 401(k) loan, can allow you to borrow from a wider choice of mortgage lenders. It might also potentially help you qualify for a better interest rate and avoid PMI.
Downsides of borrowing against your 401(k) to fund your home purchase
Unfortunately, while the benefits of a 401(k) loan may make it sound attractive, there are considerable downsides to consider as well.
- You'll be putting your retirement at risk: The money you take out of your 401(k) won't be invested and growing for retirement. Chances are good the return on investment you would have received by leaving your money invested would have been higher than the return on investment (ROI) from the interest you pay yourself (or the appreciation on your house).
- You'll have less money in your budget. You have to repay the 401(k) loan, which means that you're committing part of your future paychecks towards it. You won't have access to this money for other things, such as the expenses of homeownership.
- You'll have to repay the loan quickly. Generally, you have only five years to repay your 401(k) loan. This could mean making very large monthly payments if you borrow a lot.
- You could end up owing penalties if you can't pay back the loan: If you aren't able to repay the loan, it will be treated as a withdrawal. You'll have to pay ordinary income taxes on it, and will also be subject to a 10% penalty associated with early withdrawals if you weren't 59 ½ or older when you took the money out.
- You could accelerate repayment if you leave your job: If you are fired or quit, you will have to pay back the entire loan amount by the due date for filing taxes that year -- including any extensions. This could mean you have to repay your loan very quickly or face penalties.
In many cases, the short repayment timeline -- which leads to high payments -- coupled with the risk of penalties if you can't pay back the 401(k) loan make borrowing from your 401(k) a bad idea. That's especially true when you also factor in the lost opportunity for gains in your retirement savings account.
We have resources that may provide an alternative to taking money out of your 401(k). These include:
However, you need to consider your individual situation when deciding what's right for you. If you have no other options and you need to take a 401(k) loan to qualify for an affordable mortgage and be able to buy a home, then you may decide it's worth doing. Just be sure you can make the payments and be aware of the considerable risk you're taking on before you act.
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