When financing a first home, many home buyers struggle to save the funds for a down payment. Setting aside 20% of $226,700, the median home price in the United States is the equivalent of their annual income for many families. You might have to get creative.
This is why many employers and the IRS have set up provisions that allow home buyers to borrow for their down payment from a 401K. According to one survey, 29% of Americans borrow from their 401Ks, and 25% of those who borrowed did so to finance a home purchase. It’s obviously a popular option. But is it the best option?
It’s up to your employer as to whether or not they will offer a 401K loan program. They’re not required to do so. And they can set their own limits on the program, which are usually designed to protect borrowers. Your Human Resources department should be able to provide you with information on your company’s loan program, check with them before making a 401K loan part of your home purchase plan.
When weighing the pros and cons of borrowing from your retirement, talk to your realtor. They will have real-life examples of how this has worked out for their past clients, and experienced advice to offer.
Pro – Borrowing from Yourself
You’re the owner of your 401K, which means that when you borrow against it, you pay interest to yourself. While it’s a pro to make money off your loan, instead of paying it to a bank, it’s unlikely to be the same as how much you’d make if the funds had been invested in the market.
Interest rates on 401K loans are typically tied to the Prime and can be quite low. The interest that you’re paying yourself is tax-deferred, just like any gains in a 401K portfolio. You won’t pay taxes on it until the funds are distributed after retirement.
Con - Borrowing Limits
When you borrow money from your 401K, you can only borrow up to 50% of the total amount in your account. And you can only borrow against vested funds. There is a $50,000 legal limit on your total borrowing amount and a $1,000 minimum.
The average down payment in your area might not be 20% of the selling price, however. And if you’re just $5,000 shy of a down payment that would help you avoid paying Private Mortgage Insurance, you can borrow only that amount from your 401K.
The repayment term can also be a negative. Unlike using a HELOC or second mortgage to fund your down payment, 401K loans rarely have 30-year repayment terms. You may have to pay the loan back in as little as five years.
Pro – Control of the Borrowing
If you decide to borrow from your 401K, you decide which stocks and mutual funds to sell to fund that loan. You can unload poorly or underperforming assets in your portfolio. The interest paid on the loan could be a higher return than those assets.
Con – Potential Missed Growth
The purpose of a 401K is to fund your retirement, not a home purchase. If you’re using the funds as a loan, you could be missing out on stock market growth. The money could be working for you in other, and better performing, ways.
You can also lose out on matched contributions from your employer if you’ve borrowed against your 401K, which could add up to far more than the down payment you put down. Talk with your Human Resources department
Con – Potential Job Loss
If you’re laid off or quit your job, you’ll have 60 days to pay off the loan. Otherwise, the IRS taxes it as a distribution. You’ll owe taxes plus a 10% penalty if you haven’t met retirement age criteria.
This can be quite costly, and you could your retirement at risk. Over 44% of those who borrowed from their 401K in the above survey ended up regretting it.
When evaluating your financing options, partner with an experienced, local real estate agent for guidance and support throughout the home-buying process. They can help you weigh the pros and cons and crunch the numbers for different scenarios. Reach out to Clever to be connected with a Partner Agent in your area today.