Buying a home is a significant part of the American Dream. But saving enough money for a down payment is usually the biggest obstacle for first-time homebuyers.
According to the National Association of Realtors, the average down payment on a home is around 11 percent of the purchase price. This translates to $33,000 on a $300,000 mortgage.
Eleven percent can add up to a significant amount of money. Plus, you will usually have to pay 2 percent to 5 percent for closing costs.
One method that some people use to finance their down payments is to tap into retirement accounts, such as 401(k)s. In fact, according to CNBC, roughly 10 percent of homebuyers use money from retirement accounts to help pay for down payments and closing costs.
There are two ways to use a 401(k) to finance a home purchase: borrow from it and withdraw money from it.
Here are the pros and cons of these two options.
Borrowing from your 401(k)
If you would like to borrow from your 401(k) to fund a home purchase, then you must do it through a "401(k) loan." A 401(k) loan is a loan that lets you borrow a certain amount of money from your 401(k) at a set interest rate. As with a standard loan, the money that you borrow will have to be repaid within a certain period of time.
Not all 401(k) plans allow for loans, so the first thing you should do if you are thinking about taking out a 401(k) loan is to check with your employer to see if your plan permits loans.
A 401(k) loan has many advantages. First of all, it can be accessed extremely quickly. In fact, in most circumstances, 401(k) loans can be obtained within a few days and just take a few clicks of a mouse to obtain.
So, if a house you love suddenly pops up on the market at a good price and you need cash immediately to buy it, a 401(k) loan is an excellent option.
Another key advantage of 401(k) loans is that they typically do not require credit checks and lengthy applications. Why not? Because you are borrowing money from yourself, so you are the only party taking on risk. The loan origination fees for 401(k)s also tend to be very low compared with other types of loans. This is another nice benefit of 401(k) loans.
Additionally, unlike other types of loans, the interest that you pay back on your loan goes to you. You will not have to spend money making interest payments to a financial institution or to another lender.
However, although 401(k) loans have many advantages, there are also some disadvantages. For example, payments on the loan are not considered 401(k) contributions. So, if your employer has a 401(k) match, your employer will not match payments you make on the loan.
If you take a 401(k) loan and then leave your job, you must repay the loan before you file taxes for the year in which you left your job, otherwise it's considered a withdrawal and taxed at ordinary income tax rates. For instance, if you had a loan on your 401(k) and left your job in October, you would have until April 15 of the following year to repay the loan.
Another thing that could be viewed as a disadvantage by some people is the limit on how much you can borrow. The IRS limits the amount of money that can be borrowed through a 401(k) loan to the lesser of 50 percent of your account balance or $50,000.
If you are trying to buy a million-dollar home, then borrowing from your 401(k) will most likely not be the best option. Additionally, you probably have to repay your 401(k) loan within five years and make payments at least quarterly. Some plans will give a borrower a longer repayment window—up to 15 years – if the loan is for the purchase of a primary residence.
One last disadvantage of a 401(k) loan is that it can make it more difficult to qualify for a mortgage. Taking out a 401(k) loan pushes your debt-to-income ratio higher, which is not ideal when you're trying to qualify for a mortgage.
According to Brian Sullivan, public affairs manager for the Department of Housing and Urban Development (HUD), "When somebody borrows money against their retirement fund, of course, that would impact their debt-to-income ratio. When somebody is borrowing to borrow, that might negatively impact their qualifications for the loan itself just by virtue of the added debt burden that they would bring to transaction."
Withdrawing money from your 401(k)
If you do not want to get a 401(k) loan for your down payment, then withdrawing money is another option. However, like borrowing money from your 401(k), there are pros and cons to withdrawing money from your 401(k).
The first thing that you need to know about making a 401(k) withdrawal is that many employer plans simply do not allow 401(k) withdrawals before the age of 59 ½. Check with your employer to see if a withdrawal is even an option.
Many employers allow 401(k) withdrawals before this age, under certain circumstances. One of these circumstances is financial hardship. But your employer may require you to demonstrate that you are experiencing financial hardship before they allow you to make a withdrawal.
If you are able to make a withdrawal from your 401(k), there are many advantages to using it as a funding source. For example, the money does not have to be repaid. Also, unlike a 401(k) loan, the IRS does not set a limit regarding how much you are allowed to withdraw.
Further, you will not be required to pay any interest on your withdrawal. This is a great benefit.
Now for the disadvantages: If you are under the age of 59 ½, you will be charged a 10 percent early-withdrawal fee. So, right off the bat, you lose 10 percent of the money you take out.
But that is not all an early withdrawal will cost you. The withdrawal is considered income, so you will pay federal and state taxes on the amount withdrawn.
For example, if you withdraw $100,000 from your 401(k) before you reach age 59 1/2, you will pay $10,000 in early-withdrawal fees plus taxes. If you’re in the 24 percent tax bracket, that’s another $24,000 in federal taxes. So, $34,000 is a steep price to pay for some quick cash.
Which option should you choose?
The option that is best for you depends on what your goals are, and which downsides you are willing to deal with, because both options have downsides.
The biggest downside of 401(k) loans is that they have to be paid back. The biggest downside of 401(k) withdrawals is that you will take a massive tax hit. If your top priority is to prevent losing a lot of money, then you should consider going with the 401(k) loan.
However, if your top priority is to not have to pay back any money that you take out, then you should go with the 401(k) withdrawal.
Regardless of which option you take, your 401(k) will still take a big hit, at least temporarily. Removing any money invested in a tax-deferred retirement plan will prevent you from earning the compound interest that you gain if you leave the money in your 401(k).
Other down payment funding options
Taking money from your 401(k) either in loan or withdrawal form is not the only way to come up with money that you can use for a down payment on a house. Here are some other options that are available:
If you're a first-time homebuyer, you can get an FHA loan to finance your home purchase. With an FHA loan, you will not have to put down 10 to 20 percent. Instead, you can put a minimum of 3.5 percent down as long as your credit score is above 580.
Gift from friends or family
If you have a generous friend or family member who is willing to help you out with a down payment, then this is a good option. Most lenders will allow gifts to be used for a down payment. However, the amount of gift money that can be used for the down payment may vary depending on the type of loan and the lender. Be sure to ask your lender what their policies are before you try to use a gift as a down payment.
One party whom you are not allowed to get a gift from for a down payment is the seller. As Sullivan at HUD explains, "We (HUD) have long prohibited that the sources of payment be the seller. It is critically important that there be separation between buyer and seller in the transaction. There was a time, for a while, when the FHA would insure mortgages where the buyer of the home was contributing a down payment that was financed by the seller. We found those loans to be incredibly risky and defaulted at a much greater rate. And so, we prohibited that practice."
Like 401(k)s, IRAs are retirement planning vehicles that many people choose to use to make down payments on their homes.
However, unlike 401(k)s, there is not a 10 percent penalty to withdraw money from an IRA to put toward a down payment on a home. That is true as long as the amount withdrawn does not exceed $10,000. You will still have to pay income tax on the amount withdrawn if it is a traditional IRA.
There are a variety of down payment assistance programs offered by the federal government and state governments. These options are loans, second mortgages, and grants.
Loans and second mortgages have to be repaid, but grants do not. Whether or not you will qualify for assistance programs depends on your income and your location. If you qualify, the programs are worth the application effort.
Even though there are many options available for funding a down payment on a house, one of the best methods is to simply sell assets that you already own. For example, if you own an expensive car, you can sell it and buy a cheaper car. Then, you can use the difference to pay for your down payment.
The same can be done with valuable jewelry, works of art, music equipment, etc. If you can avoid borrowing money from your retirement accounts or from lenders, it could be in your best financial interest to do so.
Whether you decide to take a 401(k) loan or a withdrawal, be sure to consult with your 401(k) plan manager to understand the details about fees, taxes and repayment time period before you make a decision.