If you’re in the market for your first home and are lucky enough to have a 401(k) through your work, you might be wondering if you can use that money as part of your down payment. “It might be a worthwhile tool to investigate,” says Betsy Mills, Director of Lending at TCHFH Lending, Inc. (Twin Cities Habitat for Humanity’s subsidiary mortgage company). “But we recommend talking with a financial planner if you’re considering it.”
A 401(k) is a retirement account that lets you make tax-sheltered yearly deposits. Its value grows over time. If you wait until retirement to withdraw from the account, you save big on your taxes.
The 401(k) has long been one of the best ways to save for retirement. Not only is it easy to use, it lets your employer match your contributions. Start early and you might have millions of dollars in time for retirement. Sometimes, you can use the value from your 401(k) early. One way to do it is to use your 401(k) to buy a home – but should you?
You can absolutely use your 401(k) to buy a home. But the details make it a tough decision. There are two ways to use your 401(k) to buy a home:
- You can take funds directly out of the 401(k)
- You can take a loan against the account value
Let’s look at the two options and what they really mean.
401(k) withdrawal to buy a house
Usually, you’re not supposed to withdraw funds from your 401(k) until age 59. If you lose or leave your job, you can withdraw at age 55. Any withdrawal before this gets a 10% early withdrawal penalty, plus taxes you must pay on any 401(k) withdrawal.
If you need more than $50,000 or your 401(k) provider does not allow loans, then you will need to make a withdrawal. This has special rules; it’s called a “hardship withdrawal.” Usually, the IRS allows it if you need money to pay for a primary residence.
There are two drawbacks:
- You’ll almost certainly pay a 10% penalty – exceptions are available, but they are rare
- You’ll owe income tax on the amount, which cannot be more than your financial need
In effect, this means you’ll end up paying income tax on your withdrawal “out of pocket,” no matter how much you need to spend. Plus, your 401(k) will lose some of its growth. Even if you start to rebuild as quickly as you can, you’re sure to lose a big amount of future value.
401(k) loan to buy a house
A 401(k) loan to buy a house is the better option. When you borrow against your 401(k), you do not get the early withdrawal penalty. You don’t have to pay taxes on the amount you use, either. But you are required to pay yourself back – with interest. Plus, the loan term is usually just five years.
There are a few other warnings:
- Repayments into your 401(k) account don’t reduce your taxable income at tax time
- You do not receive any matching employer contribution for the repayment deposits
- You can borrow a maximum of $50,000 if your account value is $100,000 or more
- If your account value is below $100,000, you can borrow half the total amount
“As with any debt, a loan taken out against your 401(k) has to be factored into your debt to income ratio (DTI) for the purposes of getting a mortgage,” Betsy explains. If, for example, you borrow $15,000 from your 401(k) and pay it back over five years at 4.25% interest the payment will be approximately $275 a month, which counts against your DTI.
First-time homebuyers should check with a financial advisor before using their 401(k)
Your 401(k) money is yours – and you have a right to it. But before you decide anything, it’s a good idea to talk to a financial advisor that you trust.
As you explore your homebuying options, consider TruePath Mortgage, which is a special home loan option for first-time homebuyers with preferential rates and no down payment requirement. Get more tips and information for first-time homebuyers by downloading our guide.