Dipping into your 401K is a common alternative to saving for a down payment. For many people, the ability to access that money easily, pay themselves back with interest, and the feeling that it’s already your money make it an attractive option for buying a home.
The high risk of pulling money from your 401K, plus the wealth of other alternatives to achieving a healthy down payment, make it an overall poor option for most buyers.
Why you should leave your 401k alone
Withdrawing from your retirement fund before the age of 59.5 incurs a 10% penalty that is added to the balance of the loan. You’ll also have to pay income tax on this penalty.
Taking a loan out of your 401k for a home purchase may affect your ability to get a mortgage and decent interest rates. The loan is considered additional debt which could affect your debt-to-income ratio. You also typically only have five years to repay a loan from your 401k which means high monthly payments.
Appreciation on your 401k is generally very good and quite stable over time. Withdrawing or taking a loan out will reduce the amount of money you have in the market, bring in smaller gains and leave you with less at retirement.
The biggest missed opportunity: During the time you have a loan out on your 401K, you generally can’t keep contributing to it, so if the market is doing great, you’re missing out. If your company matches your contributions, it’s an even harder hit to your potential earnings.
The money you use to pay back your loans is not tax sheltered, meaning it’s spent after tax dollars and can’t be deducted on your tax returns. When you begin withdrawing that money again in retirement, you’ll be double-taxed.
If you lose your job or quit, you generally only have 60 days to repay the balance of the loan. If you can’t pay back your loan, you’ll likely have a number of taxes and penalties added to the balance. It’s a high stress deadline that usually isn’t worth the risk.
Why you don’t need your 401k for a down payment
There are a number of federal, state, and local programs that help homebuyers, and especially first-time homebuyers, with down payments. Some of them offer loans, and some offer grants that don’t need to be paid back. Most of them have set criteria so it’s worth doing your research to find out if you qualify for any down payment assistance programs.
One of the best reasons for not taking money out of your 401K is that you probably don’t need it if you’re planning to put 20% down to buy a house. Putting in a 20% down payment is a great way to avoid PMI (private mortgage insurance) but doesn’t provide much more benefit. Many mortgage lenders only require 3% down, and putting less down means you have more cash in the bank, a stronger emergency fund, and much better leverage in your investments.