Raising the money for a down payment on a home could be the most challenging step towards homeownership. One way to get the amount you need is to borrow against your 401(k)--although there are numerous options you can consider depending on what's wise for you at the moment.
But first, what’s the real deal behind borrowing against your 401(k)?
More than 50 percent of 401(k) plans include a loan provision that gives participants the option to borrow against their savings. But is it really advisable to borrow against the balance of your employer-sponsored retirement account to cover your down payment? What are the potential risks to doing so?
In this article, we'll answer some questions about how you can effectively pull off getting a loan from your 401(k) without future repercussions on your financial health.
Should I borrow against my 401(k)?
Frankly, there are only a few instances in which you should consider taking this kind of loan. It works only if you are a responsible and disciplined borrower--and even then, real estate experts advise considering this option only if you've exhausted all your other options.
Still, it can be a wise decision as long as you know what you’re getting into. If it is the most sensible way to start living comfortably in your own home, borrowing against your retirement savings could be worth it.
How does it work?
You can borrow up to half of your 401(k) balance or $50,000, whichever amount is smaller. For example, if your balance is $90,000, you are allowed to borrow up to $45,000.00; but if you have, say, $130,000, you are allowed to borrow $50,000. However, just because you can borrow up to $50,000 doesn't mean you should. Be wise in deciding how much to borrow, and avoid borrowing more than you really need for your down payment.
Once you’ve taken out the loan, you will then have to repay the amount and its corresponding interest on a monthly or quarterly basis. A typical 401(k) loan must be repaid in five years or less, although a longer repayment period may be approved for those who are borrowing for a down payment for a primary residence.
What are the advantages?
There are a lot of reasons why a lot of home buyers are attracted to the option of borrowing from their 401(k) account. For one, most buyers like the idea of owing themselves money, instead of owing someone else (in this case, banks and financial institutions).
It also possible to receive the money quicker than you could with a traditional loan from a bank, since you won't need to undergo a credit check in order to get approved. Interest rates are also relatively lower with 401(k) loans. This makes borrowing from yourself the quickest, simplest, and cheapest way to get the cash you need for your down payment. Receiving this loan is also non-taxable unless repayment rules are violated, and it does not affect your credit rating.
The great news is, if you pay back your loan on schedule or in advance, it will have little to no effect on your retirement savings progress.This being so, the impact of a 401(k) loan on the progress of your nest egg can be minimal, neutral or even positive--although the most common scenario is for the cost to be less than that of paying "real interest" on a bank or consumer loan.
What are the risks?
Now that you know the advantages of borrowing against your 401(k), it's time to learn about the substantial risks that come with it.
If you fail to make payments for three months, the amount you borrowed will be considered a distribution from the account, which the IRS will label as taxable income. A withdrawal penalty of 10% will apply to borrowers who are aged 59 ½ and below. These dangers may be fairly easy to prevent if you have a steady stream of income, but it will be a different case if you have to leave your job for any reason. If this happens before the loan is settled, you will be required to pay the entire outstanding balance within 60 days. If you are unable to do so, the IRS will charge you with the abovementioned penalties.
And then there’s the more subtle, but more significant long-term consequence: By borrowing from your retirement savings, you’re losing out on the possibility of compounding interest on that money. To make matters worse, people who take out a 401(k) loan often decrease or even stop contributions to their retirement account during the years they’re repaying it. Those factors can have a tremendous negative impact on your savings.
Impact at retirement: Retirement money that you’ve borrowed will not accrue interest until you’ve paid it back. Depending upon the amount you’ve taken out, it can make a big dent in your fund.
Some employers will disallow new 401(k) contributions if there’s an outstanding loan, thus compromising your future retirement nest egg.
When should I NOT consider borrowing against my 401(k)?
While it is a sensible answer for short-term financial needs and highly important purchases, financing a home with a 401(k) loan is not for everyone.
When you purchase a home, you will immediately be required to pay for your monthly mortgage dues--not to mention, the added costs of homeownership such as utilities, maintenance, etc. If your monthly income can barely cover THOSE, taking on a 401(k) loan can end up taking a dangerous toll on your finances. Some people may justify this with plans of making a lump sum payment, but keep in mind that you would still have to qualify based on your monthly income and ability to make regular payments.
For further guidance, it's highly recommended to speak to your financial advisor or ask your Realtor for local referrals to loan experts who will be glad to help you!