Is It a Bad Idea to Borrow from My 401(k) to Get a House?
“Should I borrow from my 401(k) to get a house?” is a question that comes up quite a bit, especially with first-time homebuyers.
It’s understandable because it can be difficult for many first-time homebuyers to accumulate enough savings to make a down payment.
It’s standard for banks to require as much as 20% down, and with home prices on the rise, that means down payments are also higher.
As a result, investors are willing to borrow from their 401(k)s to cover the down payment.
In fact, the TIAA-CREF Borrowing Against Your Future Survey found that “nearly one-third (29 percent) of Americans who participate in a retirement plan say they have taken out a loan from the savings in their plan.”¹
Of the 29% who borrow from their 401(k), one-third of them did so to purchase or renovate a home.²
It’s easy to see why it is tempting to borrow from a 401(k) to get a house.
That doesn’t mean it is the right decision for everyone.
So, I shouldn’t borrow from my 401(k) to get a house? Watch this video for a direct answer.
Taking a 401(k) loan may seem like a good idea, but if you don’t know what you’re getting yourself into, it could cost you a lot more than you bargained for.
A 401(k) loan may impact the quality of your retirement, have negative tax consequences, and cost you more in the long run.
The Basics of 401(k) Loans
There is a reason some people say yes when asking, “Should I borrow from my 401(k) to get a house?”
Many people like the idea of being their own bank by borrowing and paying back their own retirement fund.
But, it is important to keep in mind that there is much more to 401(k) loans than acting as a personal bank.
The first thing to know is, not all 401(k) plans allow for investors to borrow against their 401(k)s.
However, for those that do, here are the rules according to the IRS:
Additionally, some 401(k) plans prohibit you from making additional contributions until the loan is paid off.
Should I Borrow from My 401(k) to Get a House?
Which brings us back to the question: Should I borrow from my 401(k) to get a house?
The short answer is NO.
If you’re a first-time homebuyer, it’s wise to weigh the expanding money now in your 401(k) and how it is growing versus the damage it may ultimately have on what you hope to save for retirement.
Investopedia explains, “It is common to assume that a 401(k) loan is effectively cost-free since the interest is paid back into the participant’s own 401(k) account. […] There is an ‘opportunity’ cost, equal to the lost growth on the borrowed funds. If a 401(k) account has a total return of 8% for a year in which funds have been borrowed, the cost on that loan is effectively 8%. [That’s] an expensive loan.”³
Moreover, if the main reason you want to borrow from a 401(k) to get a house is because you are a first-time buyer, there are many alternatives available.
Look for First-Time Homebuyer Alternatives
There are alternatives such as lower upfront costs for a first-time home buyer and even lower credit requirements.
Sometimes the down payment can be as little as 3.5%.
In addition to shopping around at your local credit union, here are a few other alternatives that may help first-time homebuyers:
Before you dip into your 401(k) to cover down payments, look into these alternatives.
If you really need money for a house, we recommend you consider all the following issues before taking out a loan from your 401(k).
Weigh the Tax Consequences
It’s critical to weigh the tax consequences when you borrow from a 401(k) to get a house.
When you borrow from your 401(k), you’re borrowing pre-tax money.
But then when you make the loan payments back to the 401(k), you pay back with after-tax money.
And this money will then get taxed again when it comes out of the 401(k).
In other words, if you borrow from a 401(k) to get a house or for any reason, you will be taxed twice.
Think about the Possible Penalties
It is also wise to think about the potential penalties of borrowing from a 401(k). What happens if you change jobs or are laid off?
One penalty for this situation is having to pay back the loan in significantly less time.
Under the Tax Cuts and Jobs Act (TCJA) passed in 2017, 401(k) loan borrowers have until the due date of their tax return for the year of distribution to pay it back.
If you cannot repay the loan balance in the mandated time frame, the loan will be treated as an early withdrawal.
Should this happen, in addition to having to pay the 10% early withdrawal penalty if you are under age 59½, you’ll also owe income taxes on the full balance of the loan.
Know the Costs
Just as you take time to figure out the costs of homeownership, you need to look at the costs associated with a 401(k) loan.
In addition to taxes being costly, there are also opportunity costs.
Many 401(k) plans do not allow you to make additional contributions until the loan is paid off.
This means missing out on compounded earnings. For example, if your employer offers company matching, you’ll miss out on those additional funds as well.
If it takes you five years to pay back the 401(k) loan, that’s a lot of money you may miss out on.
For example, if you have $50,000 in your 401(k) and take out $20,000 for a down payment, that remaining $30,000 could potentially grow to $116,090 in 20 years with a 7% annualized return.
If you left the $50,000 in your 401(k) instead of using it to purchase a new home, that $50,000 could grow to $193,484 in 20 years, earning the same 7% return.
Even if your 401(k) plan does allow you to make contributions, it doesn’t mean you’ll be able to afford to pay back your loan and make contributions at the same time.
Sadly, this is the case for many borrowers.
TIAA-CREF Borrowing Against Your Future Survey reports, “In addition to borrowing funds from retirement savings plans, many Americans are also contributing less to their plans while they are paying back the loan. More than half of respondents (57 percent) who took out loans decreased their contribution rate during the payback period.”⁴
If you’re wondering, Should I borrow from my 401(k) to get a house? we hope you now understand the pros and cons of doing so.
Before you jump in, make sure you fully know the costs associated with taking out a loan and do your research to see what other options are available to you.
Your future self will thank you for it!
We regularly post videos with financial information and updates. Check us out on YouTube.
This content was originally published here.