401(K) Loan for Your Down Payment: What You Should Know
Buying a home often requires pulling together a large down payment. And few people have that much money sitting around in a savings account. One option for accessing the cash you need is borrowing from your 401(k).
While it might be possible to use a 401(k) loan to help cover a down payment, it’s not a decision to take lightly. Your retirement account should fund your future, and dipping into it early can have consequences that affect your financial security both now and later.
Before you move forward, read on to understand how a 401(k) loan works, the potential risks involved and whether it makes sense compared to other alternatives.
- A 401(k) loan allows you to borrow from your retirement savings without triggering immediate taxes or penalties.
- You can generally borrow up to 50% of your vested account balance, with a maximum $50,000 loan amount.
- Your employer usually deducts payments from your paycheck, but leaving your job can trigger immediate repayment and tax consequences.
How using a 401(k) loan for a down payment works
A 401(k) loan works much like a personal loan, except you’re borrowing from your retirement account instead of working with a lender. You pay yourself back, including interest, as you repay the loan.
A 401(k) loan isn’t the same as a withdrawal, however. With a withdrawal, you permanently take money out of your retirement account. And if you’re younger than age 59½, you’ll likely owe income taxes and an additional 10% early withdrawal penalty.
Loan limits
Not all 401(k) plans allow loans, and IRS rules limit how much you can borrow. In most cases, you can borrow up to 50% of your vested account balance, with a maximum $50,000 loan amount. “Vested” just means the percentage of your 401(k) funds that you own and keep even if you leave your job.
If your vested account balance is less than $10,000, then you can borrow up to $10,000.
Repayment
In most cases, you’re required to repay the loan over five years. However, plans may allow a longer repayment term if you use the loan to purchase your primary residence. The extended loan term depends on your employer’s plan rules, but most allow up to 15 years.
Repaying the loan is crucial. If you leave your job for any reason, the outstanding balance may become due in full within a short time frame — sometimes just 30 to 60 days. If you can’t repay it, your employer must treat the unpaid amount as a taxable distribution. They’ll notify the IRS, and you’ll pay taxes on your balance and potentially face an early withdrawal penalty.
For this reason, before deciding to use your 401(k) funds for a home purchase, it’s important to weigh your employment stability and your ability to keep up with payments.
If you take money out of your 401(k) as a withdrawal rather than a loan and you’re not yet 59½ years old, the IRS generally treats it as taxable income, and you’ll owe taxes at the same rate you pay on your regular income.
On top of that, you’ll likely face a 10% early withdrawal penalty. This means a $20,000 withdrawal shrinks significantly once you take out taxes and penalties, leaving you with much less for your down payment.
There are some exceptions to the 10% penalty, such as disability or medical expenses, but buying a home doesn’t qualify under IRS rules.
Pros and cons of using a 401(k) loan for a down payment
Pros
- No credit approval necessary. You won’t need to qualify with a lender to borrow from your 401(k).
- Lower interest costs. The interest rate on a 401(k) loan is usually lower than that offered by a credit card or personal loan.
- No impact on credit or DTI ratio. A 401(k) loan doesn’t show up on your credit report and doesn’t affect your debt-to-income (DTI) ratio, so it won’t lower your score or affect your ability to qualify for a mortgage.
- Flexible repayment. Some plans allow up to 15-year repayment terms on loans used to purchase a primary residence, making your monthly payment more manageable.
Cons
- Reduced retirement growth. The money you borrow is temporarily out of the market, so you miss out on potential investment growth.
- Repayment risks if you leave your job. If you quit or are terminated from your job, the loan balance becomes due quickly after your employment ends.
- Cash flow strain. You typically make loan payments via payroll deductions, which could tighten your monthly budget at the same time that you’re adjusting to new housing costs.
- Potential tax hit if unpaid. If you default on the loan, the IRS treats the unpaid balance as a taxable distribution, and you may also owe a 10% early withdrawal penalty.
Alternatives to a 401(k) loan for a down payment
If you’re hesitant to borrow from your retirement savings, there are other ways to fund a down payment. Here are a few options.
- Personal savings. Setting aside money in a high-yield savings account or money market account provides a secure, penalty-free source of funds. While it takes time to save up for a down payment, it keeps your retirement accounts untouched and growing.
- Down payment assistance (DPA) programs. Many state and local housing agencies offer grants or low-interest loans to first-time homebuyers. These programs can cover part of your down payment or closing costs, reducing the amount you need to save up or borrow. However, each DPA program is different, so if you’re thinking of going this route, your best bet is to talk to a lender in your area who can give you an overview of your options.
- Gifts from family. Mortgage lenders often allow down payments funded by gifts, provided you document the source with a gift letter. This option avoids debt altogether, although you should be clear about expectations with your friend or relative.
- Make a 401(k) withdrawal. With a 401(k) withdrawal, you take money out of your retirement account without a plan to repay it. In doing so, forfeit some of the tax benefits of that account. You’ll pay income tax on the money you withdraw and a 10% early withdrawal penalty if you’re younger than age 59½.
- IRA withdrawal. IRS rules allow you to withdraw up to $10,000 from a traditional or Roth IRA penalty-free for a first-time home purchase. You may still have to pay income tax on traditional IRA withdrawals, but it may be a less costly way to access retirement funds.
- Ask the home seller for help. One way to reduce the upfront cost of buying a home is by asking the seller to cover some of your closing costs, a deal known as “seller concessions.” In this scenario, the seller pays for a portion of your closing costs up front. The downside of asking for seller concessions is it makes your purchase offer appear weaker in the seller’s eyes and can make you less competitive in a hot housing market.
- Take out a second mortgage. If you already own a house, you can tap your home equity to fund a down payment on another property. For example, a home equity line of credit (HELOC) lets you convert your home equity into an open credit line. You only pay interest on the funds you use, typically at a variable HELOC rate. A home equity loan also helps you turn equity into cash, but with a lump-sum payout. You’ll pay interest on the full amount, usually at a fixed rate. These are both second mortgages, so you can choose either of them even if you already have a first mortgage on the home.
Frequently asked questions
In most cases, you can borrow up to 50% of your vested account balance, with a maximum loan of $50,000. Some plans may set lower limits, so check your employer’s specific rules.
Yes, because your employer typically needs to deduct payments from your paycheck. The loan may also require approval from the plan administrator.
If your 401(k) plan allows loans, you can request one through your plan administrator. Once approved, part of your investments will be sold and you’ll receive the proceeds. You’ll then repay the loan under the terms of the agreement, usually via monthly payroll deductions. IRS rules require you to make payments at least quarterly.
Generally, you can begin taking penalty-free withdrawals for any reason at age 59½. Accessing your money earlier is possible through loans or hardship withdrawals, but these often come with restrictions or costs.
It depends on your circumstances. A 401(k) loan may help you purchase a home sooner, but it reduces your retirement savings and comes with repayment risks if you leave your job before you repay the loan in full. Carefully compare this option with alternatives before making a decision.
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