Should you borrow against your 401k for house down payment?
In some ways, it can seem like an ideal match. A house down payment can be a difficult lump sum to accumulate, and your 401k balance may be your largest available source of liquid assets. IRS guidelines say that you can borrow 50 percent of your vested 401k account balance, up to $50,000. So why not put that money to good use by borrowing against it for a house down payment?
Well, although there is a case to be made for borrowing against a 401k for house down payment, there are also arguments against it. This is not a decision you should make until you understand both the pros and cons.
Seizing the Opportunity
One reason borrowing against a 401k for a house down payment can seem so tempting is the immediacy of it – it allows you to seize the opportunity right away rather than spend years painstakingly saving up for a down payment in order to purchase a home. This has the following benefits:
- Capture mortgage rates while they are low. In recent years, having 30-year mortgage rates down around 4 percent has become so commonplace that people may start to think it is normal, but it is not. Until 2009, 30-year mortgage rates had never even dropped below 5 percent, and historically they have averaged 8.4 percent. There is no telling when mortgage rates might start to return to more normal levels, and if borrowing against your 401k allows you to buy a house sooner, that can be one way to capture the opportunity presented by low mortgage rates.
- Build equity sooner. Whether you are a renter or a home owner, housing costs will probably represent a big chunk of your income, and one of the motivations for buying a home is to have those payments go toward building equity in something you own rather than paying rent to a landlord. Borrowing against your 401k could start you building equity sooner.
- Pay yourself rather than a bank. When you borrow from a 401k, you have to set up a schedule of principal and interest payments, just like you would with a bank – except the key difference is that those interest payments go into your retirement savings rather than to enrich a bank or other lender.
The temptation to borrow against a 401k plan for a house down payment is understandable, but before you do you should be aware of some potential drawbacks:
- Missing out on tax-advantaged returns. Investments in your 401k plan get to grow, with taxes on that growth deferred, until your retirement, but you will be forsaking some of that tax-advantaged growth if you pull assets out of your plan for a loan.
- Getting behind on retirement savings. Many Americans neglect to save enough for retirement, and borrowing from your 401k plan can exacerbate this problem. Yes, the idea is that you will repay that money, but unless you have a substantial income there is a chance that making those payments will detract from your future 401k contributions.
- You might compromise loan eligibility. Keep in mind that a loan from your 401k will be considered by lenders when they evaluate whether or not you meet their loan standards. So, don't take the step of borrowing against your 401k for a down payment unless a lender has indicated that you can qualify for a mortgage with that 401k loan outstanding.
- Not all 401k plans allow it. Be advised that while IRS guidelines generally allow for 401k loans, every individual plan has its own guidelines and not all allow for loans. Check with your employer to see if their 401k plan document allows participants to borrow against their balances.
- Low down payment mortgages offer alternatives. With the FHA and others offering low down payment loans, saving up for a down payment may not be such a big hurdle to owning a home. See if this is a better option than borrowing against your 401k plan for getting you into a home quickly.
Borrowing against your 401k for house down payment is a viable option, but it may not be your only alternative. Before doing it, weigh the short-term goal of buying a home against the long-term need to save for retirement, and figure out whether you are striking the right balance between the two.