Pros And Cons Of Tapping Home Equity For A Down Payment
|; Youll get a lower rate than other types of loans.||; You could lose your home to foreclosure if you default.|
|; You can borrow up to 85% of your current homes value.||; You may have to pay closing costs of 2% to 5% of the loan amount.|
|; You may avoid private mortgage insurance on your new home with a 20% down payment.||; Youll have to qualify with two mortgage payments.|
|; Youll leave more cash reserves in the bank.||; You may have a variable interest rate on a HELOC and, in turn, higher monthly payments.|
|; You may be able to make a low, interest-only payment on a HELOC.||; You may have a prepayment penalty when you pay off your HELOC.|
Mortgage pro tip: Use a HELOC or home equity loan as a piggyback down payment
If you can come up with a 10% down payment, taking out a HEL or HELOC on the home youre buying to come up with another 10% of the down payment will help you avoid PMI on a conventional mortgage. This is called a piggyback loan. It comes with an added bonus: You may be able to deduct the HEL or HELOC interest on your taxes because youre using the money to purchase the home that secures the piggyback loan.
Is It A Good Idea To Borrow From Your 401
Using a 401 loan for elective expenses like entertainment or gifts isn’t a healthy habit. In most cases, it would be better to leave your retirement savings fully invested and find another source of cash.
On the flip side of what’s been discussed so far, borrowing from your 401 might be beneficial long-termand could even help your overall finances. For example, using a 401 loan to pay off high-interest debt, like credit cards, could reduce the amount you pay in interest to lenders. What’s more, 401 loans don’t require a credit check, and they don’t show up as debt on your credit report.
Another potentially positive way to use a 401 loan is to fund major home improvement projects that raise the value of your property enough to offset the fact that you are paying the loan back with after-tax money, as well as any foregone retirement savings.
If you decide a 401 loan is right for you, here are some helpful tips:
- Pay it off on time and in full
- Avoid borrowing more than you need or too many times
- Continue saving for retirement
It might be tempting to reduce or pause your contributions while you’re paying off your loan, but keeping up with your regular contributions is essential to keeping your retirement strategy on track.
Long-term impact of taking $15,000 from a $38,000 account balance
What Happens If You Use Your 401 To Buy A House
Your 401 might be your largest asset, making it a tempting source of funds for your down payment but going this route isnt usually recommended.
Amy FontinelleUpdated June 2, 2021
Our goal is to give you the tools and confidence you need to improve your finances. Although we receive compensation from our partner lenders, whom we will always identify, all opinions are our own. Credible Operations, Inc. NMLS # 1681276, is referred to here as “Credible.”
Saving up for a down payment can be a major hurdle to homeownership, especially since it isnt the only expense in the mortgage process. You might need to come up with money for closing costs, moving costs, and modifications or furnishings for your new home as well.
If youre short on cash, one way you can fund your down payment is to draw from your 401. However, this comes with significant drawbacks.
Heres what you need to know about using your 401 for a home down payment:
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Can You Use Your 401 To Buy A House
Retirement accounts are just that: money thats being set aside for you to use in your golden years. And if you’ve been carefully saving, you might be wondering if its OK to tap those funds to use for something right now, like a home purchase, given that its an investment in its own right.
One of the most common type of retirement plans is the 401, which is often offered by companies to their workers. It provides an easy way to earmark some of your salary for retirement savings, along with the tax benefits that a 401 brings. Youll be setting aside money without paying taxes right now and then will pay the taxes when you withdraw it, which ideally will be when you re in a lower tax bracket than you are in now. In many cases, companies also match up to part of your personal savings, which is another reason that 401 accounts are so popular, since thats essentially free money.
But those funds have been set aside specifically for your retirement savings, which means that if your plan allows you to withdraw it earlier, youll pay a penalty, along with the taxes you owe given your current tax bracket. Theres usually the potential to borrow from it, though, which may be a better option.
So, while you can use your 401 for first time home purchase in most cases; the question is whether you should.
Does A 401 Loan Or Withdrawal Make More Sense
When you consider the potential tax consequences associated with an early withdrawal, a 401 loan may seem more attractive. Of course, there’s one drawback with both options: you’re diminishing your retirement savings.;
With a 401 loan, you’d have the ability to replace that money over time. If you’re cashing out an old 401, however, there’s no way to put that money back. In both cases, you’re missing out on the power of compound interest to grow your retirement wealth over time.;
One upside of deciding to borrow from a 401 for a housewhether you take a loan or make a withdrawalis that it may allow you to avoid paying private mortgage insurance if you offer the lender a large enough down payment. Private mortgage insurance protects the lender, and it’s typically required if you’re putting less than 20% down on a conventional mortgage. Private mortgage insurance can be eliminated when you reach 20% equity in the home, but it can add to the cost of homeownership in the early years of your mortgage.
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What Are Alternatives
Because withdrawing or borrowing from your 401 has drawbacks, it’s a good idea to look at other options and only use your retirement savings as a last resort.
A few possible alternatives to consider include:
- Using HSA savings, if it’s a qualified medical expense
- Tapping into emergency savings
- Transferring higher interest credit card balances to a new lower interest credit card
- Using other non-retirement savings, such as checking, savings, and brokerage accounts
- Using a home equity line of credit or a personal loan3
- Withdrawing from a Roth IRAthese withdrawals are usually tax- and penalty-free
What Is A 401 Loan
A 401 loan allows you to borrow money youve saved up in your retirement account with the intent to pay yourself back. Even though youre lending money to yourself, its still treated like a normal loan by charging interest that youre on the hook for.
When you take out a loan from your 401 plan, youll get terms like you would with any other type of loan: Theres a repayment plan based on how much you borrow and the interest rate you lock in. According to IRS rules, you have five years to pay back the loan, unless the funds are used to buy your main home, in which case you have more time to repay.
A 401 loan has some key disadvantages, however. While youll pay yourself back, one major drawback is youre still removing money from your retirement account that is growing tax-free. And the less money in your plan, the less money that grows over time. Even when you pay the money back, it has less time to fully grow.
In addition, if you have a traditional 401 plan, youll be repaying the pre-tax funds in the account with your after-tax earnings, so it takes even more in terms of working hours to repay the loan.
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Withdrawing Money From Your 401
If you do not want to get a 401 loan for your down payment, then withdrawing money is another option. However, like borrowing money from your 401, there are pros and cons to withdrawing money from your 401.
The first thing that you need to know about making a 401 withdrawal is that many employer plans simply do not allow 401 withdrawals before the age of 59 ½. Check with your plan provider or employer to see if a withdrawal is even an option.
Many employers allow 401 withdrawals before this age, under certain circumstances. One of these circumstances is financial hardship. But your employer may require you to demonstrate that you are experiencing financial hardship before they allow you to make a withdrawal.
If you are able to make a withdrawal from your 401, there are many advantages to using it as a funding source. For example, the money does not have to be repaid. Also, unlike a 401 loan, the IRS does not set a limit regarding how much you are allowed to withdraw.
Further, you will not be required to pay any interest on your withdrawal. This is a great benefit.
Now for the disadvantages: If you are under the age of 59 ½, you will be charged a 10% early-withdrawal fee. So, right off the bat, you lose 10% of the money you take out.
But that is not all an early withdrawal will cost you. The withdrawal is considered income, so you will pay federal and state taxes on the amount withdrawn.
How To Use Your 401k To Buy A House
Buying a home is one of the biggest purchases youll make in your lifetime. If youre like many homebuyers, you may not have abundant amounts of cash lying around to make a substantial down payment. However, the larger your down payment, the lower your monthly mortgage payments will be. For this reason, you might consider borrowing from your 401k for down payment funds.
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Which Option Should You Choose
The option that is best for you depends on what your goals are and which downsides you are willing to deal with, as both options have downsides.
The biggest downside of 401 loans is that they have to be paid back. The biggest downside of 401 withdrawals is that you will take a massive tax hit. If your top priority is to prevent losing a lot of money, then you should consider going with the 401 loan.
However, if your top priority is to not have to pay back any money that you take out, then you should go with the 401 withdrawal.
Regardless of which option you take, your 401 will still take a big hit, at least temporarily. Removing any money invested in a tax-deferred retirement plan will prevent you from earning the compound interest that you gain if you leave the money in your 401.
Which Option Is Best For Me
401 withdrawals are usually worse than loans, but in the current climate, they’re actually the better choice for most people. You have to start paying taxes on your distributions this year, but you can spread the tax liability out over three years, and you have the option to put back what you borrowed. If you’re able to do that, you can request that the federal government reimburse you for the taxes you’ve already paid, and then it’s sort of like taking out a loan.
Consider how much money you’re making this year and which tax bracket you expect to fall into to decide if it makes more sense to pay your taxes all at once or to spread them out over three years. If you’re earning a lot less than normal, you might be in a lower tax bracket than you’re used to, even with your 401 withdrawal. In that case, it might be smarter to pay all of your taxes this year rather than spreading them out and potentially giving a larger percentage of that money back to the government in future years when your earnings are higher again.;
A 401 loan may still be an option for you if your plan allows loans and you don’t want to worry about any tax liability this year. But you’re taking a bigger risk. If you’re unable to pay your loan back within the five-year time frame, you’ll owe taxes on the outstanding amount plus a 10% early withdrawal penalty. That could lead to a bigger tax bill and set your retirement savings back even further.
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Which Type Of Home Will Best Suit Your Needs
You have a number of options when purchasing a residential property: a traditional single-family home, a duplex, a townhouse, a condominium, a co-operative, or a multifamily building with two to four units. Each option has its pros and cons, depending on your homeownership goals, so you need to decide which type of property will help you reach those goals. You can save on the purchase price in any category by choosing a fixer-upper, but be forewarned: The amount of time, sweat equity, and money required to turn a fixer-upper into your dream home might be a lot more than you bargained for.
Whats Involved In Dipping Into Your 401 To Buy A House
Federal rules allow you to borrow up to $50,000 or half the value of the account, whichever is less, to use the money for a home purchase. You wont owe a 10 percent penalty on the withdrawal if youre under 59.5 years of age. You can repay the money without having to pay taxes.
However, if you lose your job the money will have to be repaid by your next federal tax return or it will be considered a withdrawal and youll be taxed on the sum at your full rate, plus that penalty. In addition, many plans wont let you make new contributions until you repay the loan.
So this loan can be costly in terms of what you wont be saving, as well as possibly forgoing a company match on your contributions.
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Borrowing From My 401 To Buy Land
It’s tempting to borrow from your 401 for that lakeside property. But beware.
Some 401 plans allow members to borrow from them, as long as the participant is still employed with the company. This can be useful, because it gives participants a way tap their cash balances in what is often their most significant asset without generating an immediate income tax liability or generating the 10 percent penalty on early withdrawals.
Repayment If You Leave Your Job
If you think youll want to leave your job in the next few years, review what your plan says about 401 loan repayment if you leave. Some 401 plans require you to repay the entire loan balance if you leave your job.
If you dont repay the loan in full, the unpaid amount will be treated as a withdrawal from your retirement account. Youll be required to pay income tax on the distribution and if youre under 59 ½ or dont meet another exemption, you may be charged a 10% penalty.
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Pros And Cons Of Using A 401 Loan
How do you know if the strategy will work for you? You have to weigh the alternatives:
- If the numbers work, a 401 down payment loan might have advantages. Compare what a monthly mortgage would cost with and without mortgage insurance, then compute how much you would have to pay back to your 401 each month if you were to borrow from it. Remember that mortgage insurance isnt tax deductible, so anything you spend on it is a loss. A 401 loan is money youre borrowing from yourself, so you dont lose anything.
- A home is an investment that typically appreciates over time, and the equity you build in it is an asset. When you eventually sell it, you usually can pocket a lot of its appreciated value tax free. If its an investment that makes sense to you, arranging the best finance package should be part of the equation.
- Mortgage insurance isnt cheap. Its a good idea to avoid paying it, but you need to consider your ability to repay the 401 before using it as a solution.
Why 401k Is A Bad Idea
Theres more than a few reasons that I think 401s are a bad idea, including that you give up control of your money, have extremely limited investment options, cant access your funds until youre 59.5 or older, are not paid income distributions on your investments, and dont benefit from them during the most
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Making A 401 Withdrawal For A Home
Compared to a loan, a withdrawal seems like a much more straightforward way to get the money you need to buy a home. The money doesn’t have to be repaid and you’re not limited in the amount you can withdraw, which is the case with a 401 loan. Withdrawing from a 401 isn’t as easy as it seems, though.;
The first thing to understand is that your employer may not even allow withdrawals from your 401 plan due to age. If they do allow employees to tap 401 funds early, you may have to prove that you’re experiencing a financial hardship before they’ll allow a withdrawal. Under the IRS rules, consumer purchases generally don’t fit the hardship guidelines.;
You may be able to withdraw funds from a 401 plan that you’ve left behind at a previous employer and haven’t rolled over to your new 401. This, however, is where things can get tricky.;
If you’re under age 59 1/2 and decide to cash out an old 401, you’ll owe both a 10%;early withdrawal penalty on the amount withdrawn and ordinary income tax. Your plan custodian will withhold 20% of the amount withdrawn for taxes. If you withdraw $40,000, $8,000 would be set aside for taxes upfront, and you’d still owe another $4,000 as an early-withdrawal penalty.;