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Think Twice Before Using a 401(k) for a Down Payment on a Home

man thinking about his down payment

Your 401(k) may be the greatest asset at your disposal. Believe it or not, it’s something you can use when finding funds for down payment. But is it worth it? That depends on your financial status and goals. In this article, let’s discuss using your 401(k) for a down payment.

Accessing and repaying 401(k) funds

Funds can be obtained, as you may expect, from a loan. It’s often called a 401(k) loan, and when you take one out, you will have to repay it with interest — no surprise there. The interest rate is typically set up as a formula, such as "prime rate + 1 or 2 percentage points.” The prime rate is published daily, and it is based on surveys of 30 banks' lending rates.

More often than not your loan term will be a maximum of five years, and your payment will be taken directly from your payroll.

401(k) loan amounts

There are minimum and maximum 401(k) loan amounts available to you. The minimum amount is usually $1,000. The maximum is either $50,000 or 50% of your vested balance, whichever is less. What does vested mean? Well,  that’s the amount that truly belongs to you, and it’s the amount you can take with you when you leave your employer.

Do your research. Many companies' policies range from three to seven years before you’re fully vested in your 401(k).

Cashing out 401k to buy a house

Now that you understand a bit about 401(k) loans and repayment, let’s look at how your 401(k) can be used for down payment and which situations may make sense.

Becoming a first-time homeowner

Homeownership is a dream, that may not become a reality as soon as millennials or college graduates want. With student loans at an all-time high, it can be challenging to set aside a significant amount of money for down payment and monthly homeownership costs. Though if you have a vested retirement account, it could be an option to tap into so you can pay for down payment and closing costs.

Avoiding mortgage insurance

Borrowing from your 401(k) may help cover your required 3.5% down payment for an FHA loan or 20% down payment for a conventional loan, meaning you can avoid mortgage insurance.

Tax penalties

There’s no specific penalty exemption for home purchases when you pull money out of a 401(k).

If you leave your company, you may be required to pay back the outstanding balance within 60 to 90 days or be forced to take it as a hardship withdrawal. You’ll be assessed a penalty of 10% on the amount withdrawn, and you’ll have to pay income tax on it as well.

Restrictions on investment returns

When you enrolled in your 401(k), you should have received a Summary Plan Description (SPD) which tells you what you can and can't do with your plan contributions and balances. In some cases, you will not be earning investment returns while you are repaying the 401(k) loan.

Similarly, you may also be restricted from making new 401(k) contributions (and receiving employer matches) until the loan is fully repaid.

Be sure to speak with your Human Resources department or your financial investment planner for clarification on anything that may seem confusing.

Why you don’t need to borrow from your 401(k)

Did you know a 20 percent down payment is not necessary? Have you heard it’s perfectly acceptable to use gift money toward your new home down payment? Let’s not forget there are down payment assistance programs that come in the form of grant money, forgivable loans, and non-forgivable loans. There are even some loan programs — like the VA loan or USDA loan — that have a zero down payment requirement.

From a 401(k) investment standpoint, Country Financial Investment Solutions Representative Mike Boese agrees that it’s not a great idea to take from your 401(k) for a down payment. According to Boese, “ You are typically borrowing pre-tax funds and paying back with post-tax money.  The other big negative people fail to realize is the opportunity cost. You are losing the ability to earn returns on the money you have taken out."

Curious to learn more? Read on to find out how your down payment influences your home cost.

The bottom line

It’s in your best interest to think twice and do your research before using a 401(k) for a down payment. Be sure the benefits outweigh the risks, and you’ve exhausted all other potential assistance programs.

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