Should you use your 401 (k) for a house down payment?


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Saving for a down payment can be a major barrier to homeownership, especially since it’s not the only expense in the mortgage process. You may also need to find money for closing costs, moving costs, and alterations or furnishing your new home.

If you’re strapped for cash, one way to fund your down payment is to dip into your 401 (k). However, this comes with significant drawbacks.

Here’s what you need to know about using your 401 (k) for a down payment:

Can you use your 401 (k) to buy a house?

Yes, you can use your 401 (k) money to buy a house. Here’s a quick overview of how 401 (k) accounts work:

  • Employees and the self-employed can contribute pre-tax dollars from their wages.
  • Employers and the self-employed can also contribute on behalf of the company.
  • Employers can match a percentage of their employees’ contributions.

For 2021, the maximum employee contribution is $ 19,500. The maximum company contribution and employer match, combined with employee contributions, cannot exceed 100% of your compensation, or $ 58,000, whichever is less.

Advice: When you withdraw money from your 401 (k), you pay taxes on the full amount of the withdrawal at your current tax rate. If you are under 59 and a half (or 55, if you are no longer with your employer), you will also have to pay a 10% early payout penalty.

How to use your 401 (k) for a down payment

While it is possible to fund a down payment from a 401 (k), it is generally not recommended. However, if you want to continue, there are two main ways:

  1. Borrow against your 401 (k)
  2. Make a withdrawal from your 401 (k)

Here are the main differences between 401 (k) loans and withdrawals:

401 (k) loan 401 (k) withdrawal
Must be repaid, with interest Cannot be refunded
Amount limited to the lesser of 50% of your acquired account balance up to $ 50,000 Cannot exceed the amount needed to buy your home
Could become due in full if you lose or quit your job Not affected by loss or departure from your job
Non-taxable unless you do not reimburse it Income tax is due on the amount withdrawn
No tax penalty unless it is not reimbursed May incur an early withdrawal tax penalty of 10%
May not be able to reassess while loan is being repaid New contributions can be made after

Borrow against your 401 (k)

Borrowing on your 401 (k) is usually the best option if you want to take advantage of your plan for a down payment.

If your employer’s plan allows employees to take out loans on their 401 (k) accounts, you can usually borrow up to 50% of your vested account balance or $ 50,000, whichever is less.

Advice: If your balance is $ 10,000 or less, you may be able to borrow up to your entire balance.

You will then have to make more or less equal payments – at least quarterly, with interest – until you have paid off the loan. You will usually have to pay it back within five years.

Advantages

  • No withdrawal penalty
  • Will not affect your credit

Disadvantages

  • You will have to reimburse yourself
  • May affect your mortgage qualification by affecting your debt-to-income ratio

Learn more: 401 (k) Loans: Should You Borrow For Your Retirement?

Make a withdrawal from your 401 (k)

A withdrawal is usually a worse option when it comes to using a 401 (k) for a down payment.

If your employer’s plan allows for hardship distributions, the IRS allows individuals to take early withdrawals before age 59 and a half because of an “immediate and significant financial need,” such as buying money. ‘a house.

While buying a home might not seem like an ordeal, this is how the IRS regulates these types of distributions.

You won’t have to – or even be allowed to – refund the money you withdraw. You will regularly pay income tax on the amount withdrawn, and if you are under 59 and a half, you will also have to pay a 10% early withdrawal tax penalty.

Advantages

  • Must not be refunded
  • Won’t affect your debt ratio

Disadvantages

  • Taxes and the 10% early withdrawal penalty reduce the amount available for your home
  • Permanently reduce your retirement savings

Cons of using your 401 (k)

There are a few scenarios in which it may make sense to use your 401 (k) for a down payment. For example, you can consider it if you want to:

  • Capitalize on the rapid appreciation of home values ​​and / or low interest rates
  • Build equity sooner
  • Get a more affordable mortgage payment
  • Secure a home before you’re off the market

However, it is generally not recommended to use your 401 (k) funds to buy a home, even if the situation seems ideal.

Whether you borrow as part of your plan or take a hardship distribution, the decision could have a lasting impact on your retirement savings.

Example: Your account balance will be lower, which means any returns you generate will be lower as well. Six percent of $ 100,000 is $ 6,000, but six percent of $ 50,000 is only $ 3,000 – and the effect gets worse over time.

If you take out a 401 (k) loan, you risk missing years of additional contributions and employer matching.

And, if you lose or quit your job, you may need to quickly repay the remainder of your loan to prevent it from counting as an early payout that will be taxed and penalized.

Learn more: How to save for a down payment on a house

Alternatives to using your 401 (k) for a down payment

There are more financially secure ways to speed your path to homeownership than using your 401 (k). Here are four alternatives to consider.

1. Tap your IRA or Roth IRA instead

You normally have to be 59 and a half to receive distributions without penalty from your IRA, but the IRS allows an exception for qualified distributions for first-time home buyers.

As long as you spend up to $ 10,000 in advance distributions on the purchase or construction of your first home, you won’t have to pay the additional 10% tax on it.

Read on: First-time home buyer? Here’s how to get the money for your down payment

2. Get a government guaranteed mortgage

An FHA loan allows you to deposit as little as 3.5% with a credit score of 580 or higher. You can fund closing costs and upfront mortgage insurance premiums, which means you don’t have to have a lot of cash on hand.

3. Get a low down payment conventional mortgage

With a credit score of at least 620, you can get a low down payment conventional loan. Specifically, you may want to consider loans for first-time home buyers. These include HomeReady or Standard 97 loans from Fannie Mae, or Home Possible and HomeOne loans from Freddie Mac.

If you are thinking of buying a home, be sure to shop around for the best rates. Credible makes it easy for you: you can compare multiple lenders and receive prequalified rates in as little as three minutes.

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4. Review downpayment assistance programs

Programs for first-time homebuyers are available from state housing finance agencies, local nonprofits, federal agencies, local governments, and other entities.

These programs provide down-payment assistance in the form of grants, interest-free loans, forgivable loans, and the opportunity to earn equity.

Learn more: 5 types of mortgages: which one is right for you?

About the Author

Amy Fontinelle

Amy Fontinelle is a mortgage and credit card authority and contributor to Credible. His work has appeared in Forbes Advisor, The Motley Fool, Investopedia, International Business Times, MassMutual, and more.

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About Matthew R. Dailey

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