Pros and cons of using your 401(k) to buy a house (Podcast)

Should you use your 401(k) to buy a house?

The upfront cost of buying a home can be a real challenge. Borrowers often spend thousands out of pocket, and it may take years to save up the money. So it’s probably no surprise that some buyers will tap their 401(k) to cover the down payment and/or closing costs.

But while this is an option, it’s important to understand the financial ramifications of your decision, explains mortgage expert Ivan Simental. Simental discussed the pros and cons of using a 401(K) to buy a house on a recent episode of The Mortgage Reports Podcast. Here’s what he had to say.

Listen to Ivan on The Mortgage Reports Podcast!

Options for using your 401(k) to buy a house

A 401(K) offers an employer-sponsored retirement account that allows you to contribute pretax dollars. But although you’ve earmarked these funds for retirement, the money is “technically” yours, so you can use it at any time, says Simental.

You can even tap your 401(k) to get cash for a down payment. Although lenders don’t allow you to use a loan for your down payment in most cases, a 401(k) loan or withdrawal is often acceptable.

But there are guidelines and some serious drawbacks to be aware of.

401(k) withdrawals

One option to tap your 401(k) as a home buyer is an early withdrawal, where you take money from the account before reaching age 59 1/2 (which is when you’re technically allowed to start making 401(k) withdrawals).

Unfortunately, premature distributions are subject to income tax and a 10% penalty, so borrowing against a 401(K) is often the better choice. But according to Simental, there are a few things to consider before going this route.

401(k) loans

A 401(k) loan might be another option for home buyers. But you’ll have to check with your plan provider about whether this is allowed; rules regarding 401(k) loans vary from plan to plan and by financial institution. So check with your human resources department or 401(k) provider about guidelines as well as fees, interest rates, and repayment plans associated with a loan.

Keep in mind that funds borrowed from a 401(K) must be repaid within five years unless you lose or leave your job. In this case, the entire balance would be due within 90 days of your departure. It’s considered an early withdrawal if you don’t pay, thus subject to income tax and a penalty.

In addition, you likely won’t be able to make retirement contributions while you have an outstanding 401(k) loan.

401(k) loan limits

Be mindful, too, of borrowing limits when using a 401(K) to buy a house. You can often borrow up to 50% of your vested account balance or $50,000, whichever is less. If you have less than $10,000 in your account, you might be able to withdraw the entire amount.

Pros and cons of borrowing from a 401(K)

Even if your employer allows a 401(K) loan, the question remains: Should you borrow from your retirement account to buy a house?

Pros of using your 401(k) to buy a house

The main benefit of using your 401(k) to buy a home is that it could help you buy much sooner. It often takes years to save enough for a down payment, and a 401(k) loan might put you on the fast track to homeownership.

Simental notes another benefit, too. Since you’re borrowing funds from yourself, you’re also paying interest to yourself rather than a lender.

For many home buyers, though, the downsides of tapping a 401(k) early outweigh the benefits.

Cons of using your 401(k) to buy a house

If you choose an early withdrawal, you’ll have to pay income tax and a 10% penalty on anything you take from your 401(k). That’s a serious deterrent in and of itself. But loans have their downsides, too.

In most cases, you cannot make any contributions to your 401(k) while you have a loan against it. And your employer will stop their side of any match program until the loan is paid off.

Between decreasing your account balance and missing out on a match program, a 401(K) loan could significantly reduce the earning potential of your retirement account.

Keep in mind that your 20s, 30s, and 40s — the years when many people buy their first homes — are also the most important for your retirement account. By withdrawing money at a relatively young age, you could miss out on years of both contributions and accrued interest. That can put a big dent in your retirement savings.

Explore other options before tapping your 401(k)

“The bottom line is there are better ways to buy a house than raiding your retirement savings, and I wouldn’t personally recommend this unless it was the only alternative,” warns Simental. Everyone’s situation is different, so it’s important to examine the facts and information, and then make an informed decision.

The good news, though, is that there are alternatives to using a 401(K) to buy a house.

Buyers looking for extra cash should start by exploring down payment assistance programs. Depending on your city, you might be eligible for a cash grant, a closing cost credit, or a forgivable or deferred loan with 0% interest.

In addition, you can use a cash gift for your down payment and/or closing costs. Just know that these funds must come from a family member and they must be an actual “gift.” In other words, the donor doesn’t expect repayment.

Your next steps

While using your 401(k) to buy a house is an option, it’s usually not the best one. Low-down-payment mortgages and helpful programs like down payment assistance often make it possible to buy without putting a dent in your retirement savings.

If you’re feeling strapped for cash, sit down with a mortgage loan officer and ask them about creative home buying strategies. Odds are, there are plenty of routes besides tapping your 401(k) that could provide a better alternative.