Using Your 401k to Buy a House | What You Need to Know
When buying a home, finding a large down payment can be difficult. But if you have money saved in a 401k you might be wondering if it’s a good idea to use that.
Taking money out of your 401k will affect your financial situation in retirement. For this reason, advisors often warn against touching this potential source of a down payment unless you really have no other options.
Before you choose to raid your retirement plan to help buy a home, there are many things to consider, including alternatives.
Can You Use Your 401k for a Down Payment?
You should be able to use money from your 401k to cover the cost of your down payment when buying a home. You could also use these funds to pay closing costs, but it may not be the best long-term decision.
There are limits to the amount you can take from your retirement plan. So while you can use it to contribute to your down payment, you won’t be able to buy a home outright with the money.
There are two ways to use your 401k to buy your home. You can either withdraw money from the plan or take a loan from it. Let’s review the advantages and disadvantages of each option.
The Pros and Cons of Using Your 401k to Buy Your Home
There are advantages and disadvantages to 401k loans and withdrawals that you need to understand before you choose this option.
The big advantage to taking a loan over withdrawing money is the cost. When you take a loan, there isn’t a penalty as there is with a withdrawal.
This type of loan also doesn’t add debt to your income to debt ratio. This means that the loan isn’t going to negatively affect qualification for your mortgage.
Another advantage of the loan is the fact that it doesn’t get reported to credit bureaus. Normally this isn’t the case with loans, and if you apply for credit after you have preapproval from your lender, it could mean you don’t get the mortgage you expect.
When you have a 401k loan, you can no longer contribute to your retirement plan. This also means that your employer will not be making any contributions either.
Your employer also has to allow loans as part of their retirement plan. Since this is a loan, you need to pay interest which could be 1% or 2% above the prime rate. Generally, these types of loans need to be paid back within 5 years, and to the schedule your provider requires.
This could mean that your 401k isn’t contributed to for 5 years. Your retirement fund will also miss out on 5 years worth of compound interest. Both of these things will mean that your retirement savings will be a lot less than they otherwise would be.
If you quit your job or are laid off before you have paid back the loan, you will be required to repay it soon afterward. You will only have until the tax filing date that year to repay the loan. So, for example, if you were to lose your job with the company in March, you’ll have just a month to repay the loan in full. If you aren’t able to repay the loan in time, you will be subject to a 10% penalty from the IRS.
There is normally a 10% penalty from the IRS when you withdraw money from your 401k. However, there are a few exceptions to this.
You can withdraw without penalty if you are 59 and a half or older, or if you qualify for a hardship withdrawal. With the withdrawal, you won’t have to repay the money, and that means not paying interest as you would with a loan.
Withdrawing money early from your 401k is considered income by the IRS, and this is the reason for the 10% penalty.
Unless you qualify for a hardship withdrawal or are old enough not to be charged, this will be quite a cut to the amount of money you can use for your down payment.
So if you are withdrawing $30,000 from your 401k, you are going to get charged $3,000.
Though there are benefits to a larger down payment, withdrawing money cuts your retirement savings, and you pay more tax that you could have avoided.
How Do You Qualify for a Hardship Withdrawal?
The IRS won’t charge you a 10% penalty if you need to cover medical expenses. If you don’t have medical insurance or sufficient cover, the IRS will allow you to withdraw without penalty.
The unemployed can withdraw some money to pay for medical insurance or bills, but only if you have lost your job rather than resigned. You also need to have been claiming unemployment benefits for 12 weeks continuously.
Even without meeting these hardship reasons, you could still withdraw without penalty. If you have no other way of paying higher education bills for yourself or a dependent, you could claim, for example.
Is it Better to Take Money From Your 401k to Avoid PMI?
While PMI is expensive if you don’t have 20% equity in the home, it is unlikely to cost you more than the money you would lose by reducing your pension funds.
PMI could cost you around 1%, which could be a few thousand dollars per year. However, this means taking a break from investing in your retirement plan for 5 years, missing out on employer contributions, and compound interest. And not forgetting the 10% penalty or interest you will have to pay for withdraws or loans, it is going to work out a lot worse.
What are the Alternatives to Increase Your Down Payment?
While a 20% down payment is ideal, it isn’t necessary. However, you will get better terms on your loan if you can find 20% for the down payment, including no requirement to pay private mortgage insurance and lower interest rates.
Instead, there are low and even no down payment mortgage options. For example:
* FHA loans allow down payments of only 3.5%
* Both VA loans and USDA loans offer zero down to people who qualify
* Conventional loans can even allow a down payment of as little as 3%
Even if you don’t qualify for 0%, there are other things you can do. There are down payment assistance programs in every state that could give you a grant. You could also ask a friend or family member to gift you money to pay the down payment, though there are some rules you need to follow for this.
You might be able to find a lender that has a special program providing credits to cover down payment and closing costs. Don’t consider using your 401k before you have exhausted all your other options.
Dipping into your 401k might sound like the perfect solution to help purchase a home. However, there can be pricey consequences to using that money, consequences that can negatively impact your retirement. So before deciding to use your 401k to buy a home you need to weigh all of your options.
Please consider spreading the word and sharing; Using Your 401k to Buy a House | What You Need to Know
About the Author
Top Wellington Realtor, Michelle Gibson, wrote: “Using Your 401k to Buy a House | What You Need to Know”
Michelle has been specializing in residential real estate since 2001 throughout Wellington Florida and the surrounding area. Whether you’re looking to buy, sell, or rent she will guide you through the entire real estate transaction. If you’re ready to put Michelle’s knowledge and expertise to work for you call or e-mail her today.
Areas of service include Wellington, Lake Worth, Royal Palm Beach, Boynton Beach, West Palm Beach, Loxahatchee, Greenacres, and more.
Using Your 401k to Buy a House | What You Need to Know
This content was originally published here.