You may be in the process of looking for a home or you may have already gotten pre-approved. You’ve been saving for months or even years and your down payment is still short. What now?
Coming up with adequate funds for the down payment is usually the #1 obstacle people face on the road to homeownership. To close the gap, some people tap their 401k for extra money.
This is a situation many people find themselves in for various reasons and it becomes a tough call to make. After all, this is money saved up for retirement. Should you touch it?
Note: Homebridge Financial Services are not financial advisors. You should always check with your Certified Public Accountant (CPA) and other advisors before making any major financial decisions.
How Does a 401(k) for Homebuying Work?
Your 401(k) account can be withdrawn for use at any time before retirement. The most common is during life emergencies, some of which include buying a home. These are known as “hardship withdrawals”.
Some of these include:
- Education expenses
- Medical expenses or medical insurance
- Family circumstances
- First-time home purchases
Unlike other types of withdrawals that will hit you with a 10% withdrawal penalty, first-time homebuyers can use up to $10,000 of their 401k penalty-free for a first-time home purchase. This is the government’s way of encouraging American homeownership, a cornerstone of building a secure financial future.
A 401k could be an excellent way to come up with a larger percentage of the down payment, effectively shortening your mortgage payoff period of the number of monthly payments you make.
After you take the money from your 401k, you must pay it back through installments with interest.
The Downsides of 401(k) Withdrawals
While 401k withdrawals do have an upside for a home purchase, they do have some downsides. Here’s some of them:
- Borrowing from retirement – Retirement accounts generate their power through compound interest over long periods of time. When you take a certain amount out, you are decreasing this power.
- Cannot make full contributions – During the period you owe money on your 401k, you cannot make full contributions.
- Installment Payments – 401(k) payments are like paying any other loan with principle and interest. If you already have some other debts you are paying, you may not want to add another one on top of it.
- Becoming “house poor” – Depending on the math (this is why we advise meeting with a CPA), you may find that the gap you’re using the money to fill can make you overextend yourself on your house payment while adding a debt on the backend.
- Possible immediate payback – If you leave your company for any reason and you have money to pay back to your 401k, you then have just 60 days to repay the entire balance of your 401(k) withdrawal.
Alternatives to Borrowing from Your 401(k)
As you can see, there are some hefty downsides to borrowing money from your 401k. If you find yourself short but you still want to have money for a down payment, here’s some things we recommend:
- Extra Income – There are many possibilities to make extra money towards a down payment. You can work a second job on the weekends or have a side gig that you funnel towards a down payment.
- Gifts from Parents or Relatives – If you’re lucky enough, you may be able to get a cash gift from your parents or relatives towards your next home. This is usually common during a big life event such as marriage, graduating from grad school, or having a child.
- Loan Alternatives – Many people who don’t have a significant down payment opt for a loan insured by the Federal Housing Administration (FHA loan) or one insured by the United States Department of Agriculture (USDA loan). There are many loan options available for people who have solid credit but worry they won’t be able to purchase a house without 20% down (which is a myth, by the way).
Our Final Takeaway
Borrowing money from your 401(k) can be a fantastic way to help cover the down payment for a new home! However, it also has some things to watch out for and aware of if you decide to take that step. When deciding whether to do this, think about your long-term goals and your current financial position. We strongly recommend getting with a CPA and planning a financial strategy that will help you decide if this right decision for you.