Your employer based 401K retirement plan may have an option for you to take out a loan against all, or a certain portion, of the account for “hardship” reasons. Using your 401K for down payment on a home is considered a “hardship” reason.
What is a 401K Loan?
A 401K loan is money that may be available to you based on certain conditions of your 401K retirement plan offered by your employer. The interest rate charged is typically lower than if you borrowed money from a bank. Since it is secured money. That means the collateral for the loan is your 401K. Your mortgage lender will allow it to be used for down payment requirements on a new home purchase. (see video below for further discussion on “secured” loans)
Is it a good idea? The answer is it depends. The first step is to discuss the terms with the administrator of your 401K plan. Below are a few pros and cons, but keep in mind that terms of various plans can vary. Discuss the items below with your administrator to see how, or if, they would affect you.
- The principal AND the interest you pay goes back into your account. In essence, you are paying yourself.
- No need to “qualify” for the loan. It most cases it’s a simple phone call to your plan administrator.
- It’s not a debt that is reported to the credit bureaus.
- In most cases, the payment is not considered by the lender when they calculate your qualification for the new mortgage.
- You can always pay the loan back sooner than required. You could increase your monthly payment; add extra money when you can or even pay it off in one lump sum.
- While your 401K loan is outstanding, you may not be able to make full contributions to your retirement plan.
- If your employer is one that “matches” your contributions; you may also lose out on that benefit.
- If you quit or lose your job; you may have as little as 60 days to repay the 401K loan. If you don’t repay the loan; it will be considerred a distribution. Early withdrawals of retirement funds (distributions) come with penalties and are taxed as income in that particular year. Quite often you can roll your existing retirement account from one employer’s plan to another; but typically NOT the loan.
- You will not be earning money in the market on the amount you borrowed. If if’s a strong economic time you will lose out. Of course, if the it is a weak economic time, you won’t be as harmed as much by lack of earnings.
Alternatives and Options
There are many loan programs that you may qualify for with as little as zero to 1% down payment. You’d have to sit down with your loan officer and pencil it out. Would your available 401K loan funds result in a substantially lower mortgage payment? It could make the difference in reducing your mortgage insurance expense? Would it reduce it enough to offset the risks mentioned above?
You could borrow funds for your down payment from another source as long as you secure that loan with an asset. For example, if you own a car with enough equity; you may be able to refinace the car with your bank. Keep in mind that the payment on the new car loan will figure into your qualifcation for the mortgage.
You could sell a vehicle for cash. Talk to your lender BEFORE you do this. They may ask you to produce documents to show (1) you owned the vehicle (2) the fair market value of the vehicle and (3) the proceeds you received from selling it. It is always much easier to gather documents during the transaction then have to go back and recreate them.
Selling any asset can get tricky as it easily turns into a paper nightmare. Unless you are doing it at least 3 months before you see a lender; talk to the lender before the sale. It can be difficult to document a value of a personal asset. At times it is also pretty tough to document your ownership. Trust me – a selfie of the item in your hand will not work!
Here’s a video I recently produced to give you all the details about how to use something you already own to obtain down payment money.
Don’t forget the option of a family gift. Perhaps that rich uncle (or aunt!) of yours is ready with his checkbook? Most loan programs allow for a family member to gift you a down payment with little to no funds from you.
It’s not an easy answer to give you. Borrowing from your 401K fund is usually easy and simple, but it does carry some risks. Make sure you do your research on your particular 401K plan; understand the risks and be comfortable you can live with those risks.
What do you think? I’d be interested to hear from you if you’ve had a bad experience with a 401K loan. So many buyers use this resource; it’s be helpful to hear real life stories of the outcome. Please share your comments (and questions) below.