What to Know Before Using a 401(k) Loan for a Down Payment
Talk to any first-time homebuyer and they’ll probably agree that saving a down payment was their biggest obstacle to homeownership. Some people are able to save enough over the years, and for those who can’t, using a gift from a family member is sometimes an option.
What if you’re eager to purchase, yet you don’t have enough in reserves? If there’s plenty of cash in your 401(k), it might be tempting to tap into your account and then repay what you borrow. This is a doable option, but there’s a few things you need to know before dipping into your retirement fund.
How does a 401(k) loan work?
If you have an employee-sponsored retirement plan, you’re allowed to borrow up to half of your vested account balance or $50,000 (whichever is smaller). So if you have $30,000 vested in your 401(k), you can borrow up to $15,000.
The amount you borrow must be repaid within five years, with interest. The good news is that some plans allow for longer repayment periods when funds are used for a home purchase. This, however, depends on your plans rules. To repay funds, you’ll make monthly or quarterly installments.
Keep in mind that borrowing from a 401(k) can be expensive, as you’ll be responsible for certain fees. These include a loan origination fee, a maintenance fee, and an administration fee.
What happens if you don’t repay the loan?
Even if you have every intention of repaying your loan, unforeseen events can make this difficult or impossible. If you leave your job for whatever reason (quitting, termination, a layoff, etc.), your outstanding loan balance must be paid in full within 60 days of your last day with the employer.
If you’re unable to pay, the unpaid portion of the loan is considered a distribution. The amount is then taxed as income. If you’re under the age of 59 1/2, you’ll also pay a 10% early withdrawal penalty, on top of what you owe in income tax.
How does a 401(k) loan affect the growth of your retirement account?
Even though a 401(k) loan can put you closer to homeownership, taking money from your retirement account means you’ll miss out on compounding interest. This can negatively impact the growth of your account over the next few years and beyond.
Plus, depending on your plans rules, you might be unable to make normal pretax contributions while repaying a 401(k) loan. This also impacts the growth of your account.
What are other options for a down payment?
While a 401(k) loan is convenient and gives you quick access to down payment funds, consider other options before tapping your retirement account.
Borrowing from your 401(k) might allow you to put down 20% and avoid mortgage insurance. But given the inherent risk of borrowing from your retirement plan, it might be wise to utilize other alternatives for a down payment.
Remember, many mortgage programs don’t require 20% down. Most people are able to purchase a home with as little as 3% or 5% down. Conventional home loans feature programs that only require 3% and 5%, and FHA home loans only require a minimum down payment of 3.5%. You’ll even find home loan programs that require no down payment (VA or USDA).
For more information on down payment solutions that don’t involve your retirement account, give us a call and speak with one of our experienced loan experts. With so many options available, it might be possible to buy a house without touching your 401(K).