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

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?