Read this before you use your 401(k) to buy a house

Can I use my 401(k) to buy a house?

Using your 401(k) to make a down payment on a house is generally allowed.

There are even some benefits: 401(k) loans aren’t taxed, don’t affect your credit score, and have low interest rates.

However, borrowing from your 401(k) can seriously harm your retirement savings. That’s why experts only recommend it as a last resort.

Before you decide to use your 401(k) to buy a house, consider the no- and low-down-payment mortgages available today.

Many people can buy a house with as little as 3% or even 0% down — so there’s a good chance you don’t need to tap your retirement savings to make a down payment.  

Verify your mortgage eligibility (Sep 23rd, 2020)

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Using your 401(k) to buy a house: Allowed but not recommended

You likely can’t use your 401(k) to buy a house flat-out, since there are limits to the amount of money you can take out.

However, it’s possible to use your 401(k) to cover the down payment and closing costs on a home purchase.

We’ll say right off the bat that using your 401(k) to purchase a home typically isn’t the best method.

There are plenty of alternatives to your 401(k) to get cash for a down payment — ones that won’t have the same long-term ramifications as taking money from your retirement savings.

You can read up on other ways to get money for a down payment below.

However, maybe you’ve already looked at all your options and decided the money in your 401(k) is the best way to get the cash you need to purchase a home.

In that case, there are two ways you can access your 401(k) funds.

• You can take a loan from your 401(k) account, which will need to be repaid with interest
• Or you can simply withdraw the money, which comes with a 10% penalty and income tax

Here are the pros, cons, and rules for each method.

Verify your home buying eligibility (Sep 23rd, 2020)

How to use a 401(k) loan to buy a house

A 401(k) loan is the preferred method if you need to tap your retirement savings to buy a house. That’s because there’s a much lower cost associated with a 401(k) loan than a withdrawal.

A couple other perks include:

• A 401(k) loan is usually not counted in your debt-to-income ratio, so it won’t hurt your chances of mortgage qualifying
• 401(k) loans aren’t reported to credit bureaus, so applying for one won’t harm your credit score

Unlike a 401(k) withdrawal, a 401(k) loan is not subject to a 10% early withdrawal penalty. And the money you receive will not be taxed as income.

The rules for using a 401(k) loan to buy a house are as follows:

• Your employer must allow 401(k) loans as part of its retirement plan
• The maximum loan amount is 50% of your vested 401(k) balance or $50,000, whichever is less
• The loan must be paid back with interest (typically the prime rate plus 1-2%), on a schedule you agreed to by you and your 401(k) provider
• Typically, you cannot make 401(k) contributions while you have an outstanding 401(k) loan

401(k) loans typically need to be paid back over 5 years.

However, when the money is used to purchase a home, you’re usually allowed to pay it back over a longer period of time. Rules vary by 401(k) company, so check with yours to learn more.

Drawbacks to 401(k) loans for home buying

The catch is, while you’re paying back the 401(k) loan, you usually can’t make contributions to your retirement account. And that means your employer won’t be matching contributions, either.

So all told, you could miss out on 5 years or more of retirement contributions — which will likely make a big dent is your savings later in life.

In addition, if you leave your current company or are laid off while you have an outstanding 401(k) loan, the repayment period shortens. In that case, you’ll have to repay the loan by that year’s tax filing date.

For example, if you take out a 401(k) loan on October 1, 2020, then leave your job on December 1, 2020, your entire loan would need to be repaid by April 15, 2021.

If your 401(k) loan is not repaid by the date it’s due, the remaining balance is treated as a 401(k) withdrawal. So it will likely be taxed as income and subject to a 10% penalty.

Using a 401(k) withdrawal to buy a house

401(k) withdrawals are generally not recommended as a means to buy a house, because they’re subject to steep fees and penalties that don’t apply to 401(k) loans.

If you take a 401(k) withdrawal before age 59 ½, you’ll have to pay:

• A 10% “early withdrawal” penalty on the funds removed
• Income tax on the funds removed

For example, say you withdraw $20,000 from your 401(k) to cover your down payment and closing costs.

• You’ll be charged a $2,000 early withdrawal penalty
• And you’ll have to pay income tax on the $20K, which likely comes out to around $4,000-$6,000

That’s around $8,000 gone from your retirement savings, on top of the initial withdrawal.

The standard rules for 401(k) withdrawals are as follows:

• Most 401(k) plans only allow withdrawals in cases of financial “hardship”
• However, taking a 401(k) withdrawal to buy a house is usually acceptable
• You can only withdraw as much money as is necessary to cover your immediate need
• The money does not have to be repaid

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Coronavirus update:

Under the CARES Act, you might be able to withdraw as much as $100,000 from your 401(k) with no 10% penalty. In this case, you can opt to pay income tax on the money in the same year it’s withdrawn, or over the next three years. Current CARES Act rules allow non-penalized 401(k) withdrawals until the end of 2020. Rules vary by employer and are subject to change.

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Should you use your 401(k) as a first time home buyer?

Home prices just keep rising — which means saving the required down payment to buy your first house can be really tough.

But as a first time home buyer, taking money from your 401(k) to buy a home is likely not the best option.

First time home buyers are often at a key age for making retirement contributions. The more money you put in when you’re young, the longer it has to accrue interest.

By taking money out of your 401(k) to buy your first home, you can seriously reduce the amount in your savings when you’re ready to retire.

For example:

• Say you have $30,000 in your 401(k) at age 30
• After 25 years at 7% interest, that $20K will have grown to $162,800
• But you take out $10,000 to make a down payment on your first home
• Now, your 401(k) has $20,000 in it at age 30
• After 25 years at 7% interest, it will have grown to $108,500
• So $10,000 withdrawn now means $54,000 less in your 401(k) at retirement

This isn’t to say a 401(k) loan or withdrawal is always the worst option.

But before you turn to your retirement savings, consider all the other routes available for first-timers (or repeat buyers) to purchase a home.

Verify your home buying eligibility (Sep 23rd, 2020)

Alternatives to using your 401(k) to buy a house

Many homebuyers assume they need a 20% down payment, which can make it seem nearly impossible to save enough cash to buy a house.

But home buyers no longer need 20% down.

In fact, there’s a long list of low- and no-down payment home loans that can lower the barrier to homeownership.

Some of the most popular low-down payment mortgages are:

• FHA loans allow as little as 3.5% down and only require a 580 credit score
• Conventional 97 loans start at 3% down and require a 620+ credit score
• VA loans are available to veterans and service members with 0% down
• USDA loans can be used in certain rural areas with 0% down
• HomeReady and Home Possible loans only require 3% down and have flexible requirements for first time home buyers who have little cash

But what if you don’t have a 3% down payment? After all, 3% of $300,000 is $9,000 — that’s still a lot of money.

If you need help making your down payment, there are other places to turn before your 401(k). For example:  

• Look for down payment assistance programs in your area. DPA programs are available in every state. They offer grants and low-interest loans to help home buyers cover their down payment and closing costs. If you need help buying a house, DPA should be the first place you turn
• Look for mortgage lenders that offer down payment or closing cost help. Some lenders have special programs that offer credits to cover part of your down payment and/or closing costs. Find a few examples in our list of the best lenders for first time home buyers
• Ask a relative or family friend for help. Some home loans allow you to cover your entire down payment and closing costs using gifted money, although this must be properly documented

Most of these programs are specifically designed for first-time, lower-income, or lower-credit home buyers.

So if you’re having trouble saving for a down payment for any of these reasons, there’s a good chance you could qualify.  

Do you qualify for a mortgage without 401(k) funds?

With such a wide range of mortgage options and down payment assistance on the market, most people simply don’t need to tap their 401(k) in order to purchase a home.

On top of that, today’s low mortgage rates increase your home buying power by reducing monthly payments. It’s easier to afford a home than ever before.

Before taking money out of retirement, find out whether you qualify for a mortgage based on your current savings. You might be surprised.

Verify your new rate (Sep 23rd, 2020)

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