If you don’t have money to put down on a home, but you have a sizeable 401K account at work, you may consider using that money for your down payment. While you probably know that withdrawing the funds prior to retirement results in a penalty and taxes, there is a way around it. You may be able to borrow the money from your 401K to purchase a home.
Keep reading to learn how this might work.
Borrowing Money From Yourself
Essentially, when you borrow money from your 401K, you borrow money from yourself. Keep in mind that this is a loan with interest and due dates. The difference between a 401K loan and withdrawal is the penalties and taxes. When you borrow the money, you don’t pay penalties or taxes. When you withdraw funds, you do, but you don’t pay the funds back.
Before you start, though, you’ll have to make sure that your employer allows 401K loans. Most employers do, but some don’t. In general, most companies allow you to borrow up to 50% of your vested balance. So if you have $50,000 fully vested according to the company’s terms, you could borrow up to $25,000 for a down payment.
Paying the Loan Back
Just like any other loan, you must pay the 401K loan back in full. Because each company has different rules, you should check with your plan sponsor to see the exact terms of your loan. Typically, you have up to five years to pay the loan back (plus interest). If you leave the company (either voluntarily or involuntarily), you have a short amount of time to pay the loan back in full (typically 60 – 90 days).
The amount you pay back will include interest. Typically, you pay 2 points more than the current prime rate in interest. This interest doesn’t go to a bank though; it goes directly into your 401K account. Consider it the funds to make up for the money you would have made had you left the funds in your account to grow.
Does the 401K Loan Affect Your Debt Ratio?
A large part of your mortgage application is your debt ratio. This is a measure of your current debts to your gross monthly income. Lenders look at debts like your installment loans, mortgages, and credit card loans. If you borrow the money from your 401K loan, though, they will need to include that payment as well since it’s a debt you have to pay back.
If your debt ratio isn’t close to the maximum allowed for each loan program, you may not have anything to worry about. However, if your DTI is close to the maximum allowed, the 401K loan might put you over the edge, making it harder to get approved.
Is it Smart to Use Your 401K?
Even if you know you can borrow from your 401K account, is it right to do so? Some people have no problem borrowing from themselves, knowing that the interest they are paying is going right to them and not to a bank. But, there are some things you may want to consider before doing so.
First, ask yourself, do you need the down payment? If you have no money of your own for the down payment, you may not have a choice but to borrow from your 401K unless you are eligible for a 0% down payment loan, such as the USDA or VA loan. If you have some money, though, and it meets the minimum requirements for the loan program, you may want to leave your 401K alone.
You should also consider your other options, even if you don’t have any money to put down on the home. Have you exhausted any gift options or looked at down payment assistance programs in your area? If you haven’t, you should consider exhausting all available options to you so that you can leave your 401K alone if possible.
While a 401K loan is possible, it shouldn’t be your first option. Make sure you look at all other options to determine if you can get the money you need for a down payment elsewhere. If you can’t and you need the 401K loan, make sure you understand the terms and the maturity date so that you can make good on the loan.