How to Use A 401(k) Loan for Your Down Payment
When faced with the hefty amount of cash needed to buy a home, it can be very tempting to dip into your retirement nest egg. Using a 401(k) loan for a down payment may speed up the homebuying process, but there are several potential downsides to consider.
Here’s what you need to know about tapping 401(k) funds as a homebuyer.
How borrowing from a 401(k) works
A 401(k) loan works much like a personal loan, except you’re borrowing from your retirement account instead of a lender. You’ll be paying yourself back — including interest charges — as you repay the loan.
The following guidelines also come into play with a 401(k) loan:
Loan limits
You’re allowed to borrow up to $50,000 or 50% of your vested account balance, whichever is less. “Vested” just means the percentage of your 401(k) funds that you own and keep even if you leave your job.
Repayment
In most cases, you’ll have to repay a 401(k) loan over a period of five years — however, that restriction is waived if you’re using the money to purchase a primary residence. In that case, you may have up to 25 years depending on your 401(k) plan. You also:
- Need to make payments on the loan at least every quarter and each payment must be a similar amount
- Must make the payments through your company’s payroll, so they’ll come out of your paycheck before it hits your bank account.
Taxes
Unlike an early withdrawal from your 401(k), a 401(k) loan isn’t taxable. Most loans — including personal loans, cash-out refinances and home equity loans — are also not taxable.
Employment
Your 401(k) is tied to your employer — so if you switch employers, you may have to repay the loan within 90 days. If you don’t pay it back on time, it’ll be treated as a 401(k) withdrawal or distribution rather than a loan.
Borrower beware: Taxes and fees on 401(k) withdrawals
A 401(k) loan is a more financially savvy way to access money in your 401(k) because it doesn’t come with all of the taxes and fees you’d pay on withdrawals. A withdrawal is simply taking money out — whether you intend on paying yourself back or not — rather than borrowing it through a 401(k) loan program. You’ll pay taxes and a 10% early withdrawal fee if you’re under 59.5 years old.
Pros and cons of using a 401(k) loan for a down payment
| Pros | Cons |
|---|---|
You’ll have an easier time qualifying. With a traditional loan, you’d submit financial documents and go through an underwriting process. Borrowing money from a 401(k) is much easier, however. Typically, all you'd need is your spouse’s consent, if applicable. You’ll get funds faster than with other loans. Since you don’t have to go through underwriting, you can expect to get your loan much faster. The exact time frame will depend on your plan administrator. Your interest charges will come back to you. You’ll still have to pay interest on the amount you’ve borrowed — but regardless of the interest rate, you get to keep any interest charges. You won’t have to worry about your credit history. Not only is there no minimum credit requirement, you can make a late payment without tanking your credit. That’s because information about 401(k) loans isn’t reported to the credit bureaus. You can borrow without affecting your DTI ratio. Payments on 401(k) loans usually aren't factored into your debt-to-income (DTI) ratio, so they won’t count against you whenever you apply for a new credit account. | You’ll likely receive a smaller paycheck. Many 401(k) loans are repaid through payroll deductions, which means that your paycheck might take a hit each month until the loan is repaid. In that case, you’ll need to carefully budget for your reduced income. You might miss out on some retirement savings. You might have to put your 401(k) contributions on pause for a bit — some employers prohibit new contributions while there’s a loan issued. If you do stop contributing, you’ll also miss out on any matching funds your employer offers. You’ll have another monthly payment to keep up with. Carrying a heavy debt load — especially one that requires more than 43% of your monthly income — can be stressful and financially risky. You may face tax consequences. If you default on the 401(k) loan and it becomes a distribution or withdrawal, you may have income tax and early withdrawal fees to pay. |
Alternatives to using a 401(k) loan for a home purchase
Make a 401(k) withdrawal
A withdrawal from your 401(k) is exactly what it sounds like — you’re taking money out of a retirement account and, in doing so, forfeiting some of the tax benefits of that account. You’ll pay income taxes on the money you withdraw and are subject to an additional 10% early withdrawal fee if you’re not yet 59.5 years old.
Take a 401(k) distribution
If you are at least 59.5 years old, you’re at “retirement age” and can take money out of your 401(k) without the 10% fee that applies to early withdrawals. The money is considered a distribution rather than a withdrawal, but you’ll still have to pay income tax on it.
Withdraw from your IRA
You’re not allowed to borrow from an IRA, but you can take a withdrawal or distribution from one. Similar to a 401(k), money you take out of an IRA is a distribution if you’re of retirement age and a withdrawal if you aren’t. The rules for both depend on what kind of IRA you have.
→ If you have a Roth IRA, you can take out money you contributed at any time without paying income taxes or facing a penalty. If you take out any of the money you earned on those contributions, however, you’ll pay a 10% penalty if you haven’t reached retirement age. If you are at least 59.5 years old you won’t have to pay the penalty — as long as you’ve had the account for more than five years.
→ If you have a traditional IRA, the tax scenario works similarly to a 401(k): Your distributions are taxed as ordinary income and you’ll pay both a tax and 10% early withdrawal penalty. However, there’s an exception for first-time homebuyers: They can take out up to $10,000 toward a down payment and avoid the extra 10% early distribution tax.
Use a low-down-payment loan
Using a low-down-payment loan can help reduce how much cash you have to bring to the closing table. If this lower cash requirement means you don’t have to dip into retirement savings, it can be a good option. There are many low- and zero-down-payment loan options available, including many tailored to first-time homebuyers.
Look into down payment assistance programs
Down payment assistance (DPA) programs provide money or special loans to buyers with low-to-moderate incomes, helping them shoulder the burden of their down payments and closing costs. Programs like these are typically available through federal or state agencies, though some cities may also offer them.
The assistance often comes in the form of a forgivable grant, a low-interest or deferred-payment loan or simply a second mortgage. 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.
Ask the home seller for help
One way to reduce the upfront costs of buying a home is by asking the seller to cover some of your closing costs, a deal also known as “seller concessions.” In this scenario, the seller will pay for a portion of your closing costs upfront and raise the home price accordingly. This allows you to essentially roll your closing costs into your loan. You’ll then pay them over time in the form of a slightly higher mortgage payment, rather than upfront.
While this may sound like a good deal, it’s usually not recommended to go this route unless it’s absolutely necessary. Often, asking for a seller concession makes your purchase offer appear weaker in the seller’s eyes and may make you less competitive in a hot 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. Loan options that can help you do this are:
- Home equity lines of credit (HELOCs) let you convert your home equity into an open credit line. You only have to pay interest on the funds you use, typically at a variable interest rate.
- Home equity loans also help you turn equity into cash, but their payout is a lump sum instead of a credit line. You’ll pay interest on the full amount, usually at a fixed interest rate.
These are both second mortgages, so you can choose either of them even if you already have a first mortgage on the home.
Stuck on which loan type is best for you? Read our guide to choosing between a HELOC versus home equity loan.
Get a gift from a loved one
Gift money can be used for a down payment as long as the lender can verify the source of the funds. The donor will also have to submit a statement that says the money is truly a gift and not a loan.
It’s most common for parents to give their children money to put toward a down payment but, depending on your loan program, the gift may be able to come from another source. For instance, Fannie Mae allows gift funds to come from an immediate family member, fiancé or domestic partner, while the Federal Housing Administration’s (FHA) list includes family members, employers, close friends and charitable organizations, as well as organizations or agencies providing homeownership assistance.
Should I borrow from my 401(k)?
Traditional financial advice generally discourages dipping into retirement funds, but ultimately the decision — and the money — is yours. Your best bet is to run the numbers on different scenarios and weigh all of the benefits and drawbacks.
For example, you may want to borrow from a 401(k) to pay off high-interest debt or skip private mortgage insurance (PMI) on a conventional loan, which is required for borrowers making less than a 20% down payment. If a 401(k) loan gets you to that 20% threshold needed to avoid PMI, it could save you thousands on your mortgage payments over time. Similarly, taking steps to get out of high-interest debt can be life-changing for those burdened with unaffordable debt payments.
In cases like these, the numbers may come out in favor of borrowing from a 401(k), especially if you’re confident you can repay the loan on time. But before you make a final decision, consider:
- Your long-term retirement readiness. Will you still be on track to retire at a reasonable age if you borrow from your 401(k)?
- Your finances in the short term. What will your finances look like if you can’t pay back the loan on time and have to come up with cash to pay taxes or penalties?
Frequently asked questions
Yes, your employer will know, but that isn’t the same thing as your manager or co-workers knowing. It’s not likely that anyone other than your human resources department would have access to — or reason to look at — this kind of information.
You can borrow up to 50% of your account’s vested balance, or $50,000, whichever is less.
Yes, it’s possible to take money out of your 401(k) to purchase a house outright or cover the down payment on a house. However, be aware that you’ll be taxed on any funds you withdraw. Distributions from your 401(k) are taxed as ordinary income and, if you’re under the age of 59.5, you’ll also be taxed an extra 10% for taking an early distribution.
Yes, if you use a 401(k) loan instead of taking a distribution — and pay it back on time — you won’t pay any penalties.
If you’re interested in a 401(k) loan, ask your plan administrator for the following information:
- Whether loans are permitted
- The minimum dollar amount required to obtain a loan
- The maximum number of loans permitted by the plan
- The maximum loan amount permitted
- The repayment term (number of years)
- Any interest rate information
- Any required security for the loan
- How repayments are made (for instance, payroll deduction)
- Any spousal consent requirements
Unfortunately, there’s no such thing as a first-time homebuyer 401(k) withdrawal exemption. While there is an IRA exemption that lets qualified, first-time homebuyers borrow up to $10,000 from an IRA without paying tax on the early deduction, it doesn’t currently exist for those borrowing from a 401(k).
Hardship withdrawals do exist to allow you to borrow money early under extenuating circumstances, but using a 401(k) hardship withdrawal for a home purchase isn’t currently allowed.
Put simply, 401(k)s are retirement accounts, meaning the money is ideally supposed to be used when you reach retirement age. The early withdrawal taxes imposed on 401(k)s and IRAs are meant to incentivize you to leave the money untouched until your retirement years.