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Many first-time homebuyers and investors who struggle to come up with the funds for their down payment and closing costs wonder if they should borrow from their 401k to cover these costs. While it is possible to borrow from your 401k to buy a house, it isn't always advisable. This money is meant to be spent in retirement, and borrowing it early can get tricky.
Still, if you think this might be the best option for you, we've taken a deep dive into the two ways to borrow from a 401k: taking out a loan and doing a withdrawal. Below are the pros and cons of each method, as well as some alternative financing options to consider. Armed with this knowledge, you should be able to decide whether borrowing from your 401k is the right choice for you.
The first way to borrow from your 401k is to take out a loan. As the name suggests, some of this method involves borrowing the money temporarily and then paying it back with interest over time. We've listed the pros and cons of choosing to take out a loan so you can get a better idea of how this process works.
The biggest benefit of taking a loan from your 401k is you can get access to the money you need without having to worry about paying the early withdrawal penalty or paying income tax on the money withdrawn. Additionally, while you do have to pay the money back with interest, you're essentially paying yourself, so you will be adding to your retirement fund in the process.
There are some big disadvantages to consider before you take out the money. To start, not all 401ks offer the option to take a loan from your savings. Secondly, even if yours does, there is a limit to how much you can borrow. Specifically, this limit is typically either half the vested value of your account or a $50,000 maximum, whichever is less.
Typically, if you take out a 401k loan, you'll be expected to repay the amount with interest within five years. However, during that time, your employer may block you from making any new contributions to your account, which effectively stops you from growing your retirement funds. Additionally, since 401k contributions lower your taxable income, stopping those contributions may put you in a higher tax bracket.
Lastly, if you lose your job for any reason, you're typically required to pay the amount you borrowed back in full. Some 401k accounts require this payment right away while others give you 60 days. If you're worried you may not be able to repay that amount in a lump sum, it's probably best to look into alternatives rather than borrowing from your retirement account.
After looking at the potential pros and cons of taking on a 401k loan, it's important to look at the other option: a 401k withdrawal. Unlike a loan, a 401k withdrawal doesn't have to be paid back, but it does take away from your retirement savings.
We've listed the advantages and disadvantages of this method below so you can get a sense of whether doing a withdrawal is the right choice for you.
in this case, the biggest advantage of doing a 401k withdrawal as opposed to a loan is that you don't have to worry about loan repayment. Here, the money is yours to use as you see fit. Notably, the amount of funds you can withdraw with this method is also not limited, meaning that, unlike the loan where you're limited to a certain percentage of your vested account balance, you should be able to withdraw the full amount you need for your down payment.
Your employer may not even allow you to take a withdrawal. In some cases, employers require what's known as a hardship withdrawal in order to gain access to the funds in your 401k before you turn 59 1/2. Generally, the IRS allows you to do this if you're using the money for a down payment on a primary residence. However, you'll want to check with your employer or plan administrator to see if there are any restrictions on what circumstances count.
Another downside is that you'll effectively be taxed twice in this situation. Withdrawals from your 401k count as income, so you'll need to pay tax on any amount you withdraw. Additionally, if you're younger than 59 1/2, you'll end up paying a 10% early withdrawal penalty on top of your regular income tax.
Keep in mind there are alternative financing methods that can help you leave your retirement savings intact. Think about utilizing one of these four methods so you don't have to disrupt your retirement fund.
Even though your IRA is still retirement savings, there may be advantages to choosing this investment vehicle over your 401k. In particular, if your Roth IRA plan allows for hardship withdrawals, you're allowed to withdraw any amount. However, even if hardship withdrawals are not allowed under your plan, as long as you're a first-time homebuyer, you can withdraw up to $10,000 tax-free to go toward your down payment.
On the other hand, if you have a traditional IRA, you also have the option of taking out up to $10,000 to go toward your down payment. You won't be required to pay any early withdrawal penalties on this money, but it will be taxed as income. If you take out a distribution larger than $10,000, you will pay a penalty and regular income tax on that amount.
Typically, acceptance for personal loans is based on your income and credit score. While every lender is different, in some circumstances, it's possible to take out up to $100,000 to put toward a down payment.
However, it's important to be aware that taking out a new loan can raise your debt-to-income ratio, which can hurt your ability to be approved for a mortgage. You'll want to check with your lender to verify you're able to take on more debt before taking out any new loans.
If you're not an investor and have a family member who has some extra funds, you may want to consider asking them to give you some money toward the down payment as a gift. Down payment gifts are fairly common these days, especially for first-time homebuyers. With this method, it's important to make sure that the money is transferred properly. Your lender will want to see a paper trail, and the person giving you the funds will probably have to write a down payment letter.
Lastly, it's also possible to receive help in the form of a down payment assistance program. Many states and municipalities offer grants for interest-free second loans to help ease the financial burden on first-time homebuyers. Ask your lender for more information on what programs are available in your area and how to qualify.
While it is possible to borrow against or withdraw from your 401k to buy a home, it's not the most ideal option. We suggest exploring alternative financing methods first. However, your retirement fund is your money and you are entitled to use it however you see fit. If you are going to go this route, however, it's important to make sure you understand everything that borrowing entails and the potential financial consequences you could face.
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