You might regret that you chose to plunder your retirement funds.
When trying to buy a home, it’s best to put down a 20% down payment. This allows you to avoid having to purchase private mortgage insurance (PMI). PMI ensures that lenders don’t end up with direct losses if they have to foreclose. Unfortunately, you cover the expenses of PMI, although it does not provide you with any personal protection.
A 20% deposit is also useful because it:
- Facilitates the approval of a mortgage
- Allows you to borrow less
- Saves you money on interest over time
- Makes it less likely that you will end up owing more than your home’s value
Unfortunately, finding a 20% down payment can be difficult for many home buyers. And, in fact, even finding the money for a smaller down payment can be a challenge if you’re in an expensive market.
If you decide it’s time to buy a home but you’re struggling to find the money to make a down payment, you might be tempted to borrow against your 401 (k). After all, if you have a lot of money in that account, it might seem like a great source of funds that could solve your down payment issues.
But, before deciding to go ahead with a 401 (k) loan, it is essential to consider both the pros and cons of this financial move.
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Benefits of using a 401 (k) loan to make a down payment on the house
There are definite advantages to accessing 401 (k) funds to cover the down payment costs for purchasing a home.
- You will pay yourself interest. This means that you won’t enrich a creditor like you would if you used a second mortgage or took out a larger home loan to cover your down payment costs.
- Loan approval is easy. As long as you have the money in your 401 (k), you should be able to borrow against it regardless of your credit or other financial information – as long as your work plan allows loans.
- You can generally access the cash quickly and easily. It often involves filling out a few simple forms and you can get the money really quickly, although the exact time frame will depend on your plan.
- You may be able to get a better deal on your mortgage. Making a larger down payment, made possible by a 401 (k) loan, can allow you to borrow from a wider choice of mortgage lenders. It could also help you get a better interest rate. and avoid PMI.
Cons of borrowing against your 401 (k) to finance the purchase of your home
Unfortunately, while the advantages of a 401 (k) loan may make it attractive, there are also considerable disadvantages to be aware of.
- You risk your retirement: The money you take out of your 401 (k) will not be invested and will not grow for retirement. Chances are, the return on investment you would have received by leaving your money invested would have been greater than the return on investment (ROI) of the interest you pay yourself (or the appreciation of your home).
- You will have less money in your budget. You have to repay the 401 (k) loan, which means that you commit a portion of your future paychecks to it. You won’t have access to this money for other things, like homeownership expenses.
- You will need to repay the loan quickly. Typically, you only have five years to pay off your 401 (k) loan. This could mean making very large monthly payments if you are borrowing a lot.
- You may have to pay penalties if you can’t repay the loan: If you are unable to repay the loan, it will be treated as a withdrawal. You will have to pay regular income taxes and will also be subject to a 10% penalty associated with early withdrawals if you were not 59 and a half or older when you withdrew the money.
- You could speed up your reimbursement if you quit your job: If you are made redundant or resign, you will have to repay the entire loan amount before the due date for tax filing that year, including any extensions. This could mean that you have to pay off your loan very quickly or face penalties.
In many cases, the short repayment period – which results in high payments – and the risk of penalties if you can’t repay the 401 (k) loan make borrowing on your 401 (k) a bad idea. This is especially true when you also factor in the loss of earning opportunities in your retirement savings account.
We have resources that can provide an alternative to withdrawing money from your 401 (k). These include:
However, you need to take your personal circumstances into account when deciding what is right for you. If you have no other options and you need from taking out a 401 (k) loan to qualifying for an affordable mortgage and being able to buy a home, then you may decide it’s worth it. Just make sure you can make the payments and be aware of the considerable risk you are taking before you act.