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Buying a home is a big financial investment. And even if you don’t have the cash to purchase a home outright, you’ll probably still need money on hand for a down payment.
If you haven’t saved for a down payment, though, you might be considering other ways to get access to the money you need now, including your 401(k). That’s because some 401(k) plans let you borrow money from your retirement savings and pay it back over time.
But even if you aren’t planning to retire any time soon, taking a loan from your 401(k) can come with big drawbacks, like missing out on potential investment growth. So before you dip into your nest egg, consider if it’s really the best option for you.
- Can I take out a 401(k) loan to buy a house?
- Should I actually consider a 401(k) home loan?
- Should I make a 401(k) withdrawal instead?
- What are my alternatives?
Can I take out a 401(k) loan to buy a house?
While not all 401(k) plans allow you to take out a loan from your account, a good many do. Vanguard reported that in 2018, 78% of its 401(k) plans allowed participants to borrow from their retirement accounts.
Check with your plan sponsor to see what’s allowed. If your retirement plan allows you to take a loan from your 401(k), you may be able to use that money for a home down payment or closing costs.
One important distinction to note: You can’t borrow money from an IRA.
Here are some things to consider before you take out a 401(k) home loan.How does a 401(k) loan work?
Even if your 401(k) plan allows loans, there’s a limit on how much you can borrow — typically up to 50% of your vested balance, with a maximum loan amount of $50,000.
Let’s say you have a vested balance of $130,000 in your 401(k) account. In this scenario, you wouldn’t be able to borrow the full 50%, or $65,000, of your vested balance. The most you’d be able to borrow would be $50,000.
Some plans make an exception to the 50% rule, although they’re not required to: If 50% of your vested account balance is less than $10,000, your plan may allow you to borrow up to $10,000.
You usually must repay the loan within five years. But if you use your 401(k) home loan to buy a house that will be used for your primary residence, some plans may give you more than five years.
Suspended retirement contributions
Before you take out a 401(k) home loan, think about your long-term financial goals as well as your short-term goals.
If you reduce contributions to your retirement account while you’re repaying the loan, you could lose a valuable opportunity to save for retirement, because you can only contribute up to the federal contribution limit. On top of that, if you stop contributions altogether, you’ll also miss out on any employer-matching contributions.
Repayment if you leave your job
If you think you’ll want to leave your job in the next few years, review what your plan says about 401(k) loan repayment if you leave. Some 401(k) plans require you to repay the entire loan balance if you leave (or lose) your job.
If you don’t repay the loan in full, the unpaid amount will be treated as a withdrawal from your retirement account. You’ll be required to pay income tax on the distribution — and if you’re under 59 ½ or don’t meet another exemption, you may be charged a 10% penalty.
Should I actually consider a 401(k) home loan?
Whether or not you should take out a 401(k) loan to help pay for your home purchase is a personal decision, but there are a few more things to think about before you do.
- Will you qualify for a mortgage without the loan? Using a 401(k) to stretch yourself financially and get a mortgage that’s more than you can afford probably isn’t a good idea. You may have trouble repaying the loan, which could put you in a precarious financial situation.
- What return on investment will you be forgoing? When you borrow money from your 401(k), that money is no longer sitting in your retirement account with a chance at a return on your investment — you could be missing out on years of investment growth for each year you need to pay back the loan.
- Will the loan help you qualify for a lower interest rate on your mortgage or eliminate your need for PMI? If you can save money in the long run by paying a lower interest rate or not paying private mortgage insurance, or PMI, a 401(k) home loan might make sense. But you’ll have to do the math for your particular situation — if you aren’t sure, think about consulting a financial planner to help crunch the numbers.
Should I make a 401(k) withdrawal instead?
Withdrawing money from your 401(k) before retirement, as opposed to borrowing from it, is usually a bad financial move. Not only will you be taking the money that you’ve invested for your golden years — leaving you with less for retirement — you may be hit with an early-withdrawal penalty.
Unless you’re 59½ or qualify for another exception, you’ll have to pay tax on the amount you withdraw — plus a 10% penalty. Though that penalty may be waived on up to $10,000 withdrawn from a traditional, SIMPLE or Roth IRA if you use the money to buy, build or rebuild your first home.
If you’re experiencing financial hardship, your plan may offer the option of a hardship withdrawal. You’ll still need to pay tax on the withdrawal amount, and you may also need to pay the 10% penalty. But the amount you take for a hardship withdrawal can’t be paid back to your retirement plan like a 401(k) loan can.
What are my alternatives?
If you decide that a 401(k) loan isn’t your best option, there are several alternatives that may help you purchase a home.
Down payment assistance
Are you a first time or low-income homebuyer? You might qualify for down payment assistance through a state or local program. For example, the Connecticut Housing Finance Authority offers a down payment loan, usually between 3% and 3.5% of the purchase price.
Help from family
You can use gifts from family members to help you come up with enough money for a down payment. Check with your lender about what documentation it would need for down payment funds that you’ve received as a gift.
Wait and save
While you might want to buy a house now, in some cases it may be better to wait and save up enough for a down payment so that you don’t have to borrow extra money.
Review your budget and see if there are areas where you can cut your spending. You may also want to consider earning some additional income on the side to help shorten the time it takes you to save.
If you want to learn more about whether a 401(k) loan is the right option for you, it’s a good idea to review how 401(k) loan repayment works. You should also review how much house you can afford and look closely at what it costs to buy a house where you want live — so that you don’t end up borrowing more than you can manage to repay.