Borrowing From Your 401(k) To Buy a House

Buying a home is an exciting milestone, but it requires a significant financial investment. It's important to calculate how much home you can afford and how your monthly mortgage payments will affect your budget, but there are other costs to consider.

Two of the most important are your down payment and closing costs. According to the National Association of Realtors in a 2022 report, the typical home down payment was 6% of the purchase price, but this increased to 17% for repeat buyers. That would come to $12,000 to $34,000 for a $200,000 home. Closing costs, which include administrative fees and other costs to finalize your mortgage loan, will add another 2% to 7% of the home's purchase price. 

The seller may pay some of the closing fees, but you're still responsible for assuming some of the costs. You can borrow from a 401(k) to buy a house if you don't have liquid cash savings for the down payment or closing costs. Here's what to consider before you make that move.

Getting a 401(k) Loan for a Home

There are two ways to do it if you'd like to use your 401(k) to cover your down payment and/or closing costs on home purchase: a 401(k) loan or a withdrawal. It's important to understand the distinction between the two and the financial implications of each option. 

A loan from your 401(k) must be repaid with interest. Granted, you're repaying the loan back to yourself and the interest rate might be low, but it's still not free money.

Not all 401(k) plans permit loans. Find out how much you can borrow if your plan does. The Internal Revenue Service (IRS) limits 401(k) loans of $10,000, or 50% of your vested account balance or $50,000, whichever is less. The maximum amount you'd be able to borrow is $25,000, assuming you're fully vested, if your account balance is $50,000. A 401(k) loan must be repaid within five years. Your payments must be made at least quarterly and include both principal and interest.

Loan payments are not treated as contributions to your plan. In fact, your employer may opt to temporarily suspend any new contributions to the plan until your loan has been repaid. That's significant because 401(k) contributions lower your taxable income. It could push your tax liability higher in the interim if you're not making any new contributions during your loan repayment period.

Making a 401(k) Withdrawal for a Home

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(k) loan. But withdrawing from a 401(k) isn't as easy as it seems. Your employer may not even allow withdrawals from your 401(k) plan due to age.

You may have to prove that you're experiencing a financial hardship before it will allow a withdrawal. Consumer purchases generally don't fit the hardship guidelines under IRS rules. 

You may be able to withdraw funds from a 401(k) plan that you've left behind at a previous employer and haven't rolled over to a new 401(k). But this is where things can get tricky. You'll owe both a 10% early withdrawal penalty on the amount withdrawn and ordinary income tax if you're younger than age 59½ and you decide to cash out an old 401(k). Your plan custodian will withhold 20% of the amount withdrawn for taxes. 

The early withdrawal penalty and income tax would not apply to a 401(k) loan, with one very important exception. Any remaining loan balance would become payable in full if you leave your job before paying off your loan. The entire amount is treated as a taxable distribution if you don't repay what you owe. You'd pay income taxes and the penalty if you're under age 59½ in this scenario.

Does a 401(k) Loan or Withdrawal Make More Sense? 

A 401(k) loan may seem more attractive when you consider the potential tax consequences associated with an early withdrawal. There's one drawback with both options: You're diminishing your retirement savings. 

You'd have the ability to replace that money over time with a ro1(k) loan. But there's no way to put that money back if you're cashing out an old 401(k). You're missing out on the power of compound interest to grow your retirement wealth over time in both cases.

One upside of deciding to borrow from a 401(k) for a house, whether you do it by taking a loan or making a withdrawal, is that it may allow you to avoid paying private mortgage insurance. This insurance protects the lender, and it's typically required if you're putting down less than 20% 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.

Alternatives To Borrowing From Your 401(k)

Consider whether there are other options available before you borrow from a 401(k) to buy a home.

• Down payment assistance programs: Down payment assistance programs are designed to help eligible buyers with down payments and closing costs. Some programs offer grants to qualified buyers that don't have to be repaid. Others offer matching savings programs, similar to a 401(k), that match every dollar you save toward your down payment, up to a certain amount. 
• Down payment gifts: Consider asking them to gift money for a down payment if you have family members who want to support your efforts to buy a home. The amount of money that can be gifted and the amount you have to put toward the down payment out of your own funds may vary based on the type of mortgage you take out. Down payment gifts must be thoroughly documented. The lender might not allow you to use those funds otherwise. 
• IRA withdrawal: You can withdraw up to $10,000 from your IRA toward a down payment, if you have one. You won't incur the 10% early withdrawal penalty, but you'll still owe income tax on the amount you take out if you're withdrawing from a traditional IRA. 

Borrowing from a 401(k) does have certain benefits, but the impact on your retirement and the potential that you'll owe more in taxes must be weighed carefully before you commit.

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