Borrowing from Your 401k to purchase a home.

Using Your 401k for a Down Payment

There’s no specific penalty exemption for home purchases when you pull money out of a 401k, so any money you take out will be classified as a “hardship exemption.” You’ll be assessed a penalty of 10% on the amount withdrawn and you’ll have to pay income tax on it as well.

If possible, roll over the amount you want to withdraw to an IRA, so you can avoid paying the penalty. However, you can’t roll over a 401k that’s with an employer for whom you are still working. If you have an old 401k from a former employer, roll that. Since a rollover can take time to process, fill out the necessary paperwork as soon as possible.

Borrowing from Your 401k

Another option with a 401k is to take out a loan. Your loan can be up to $50,000 or half the value of the account, whichever is less. As long as you can handle the payments (yes, you have to pay back this loan), this is usually a less expensive option than a straight withdrawal. Though you will pay interest, you won’t pay taxes or penalties on the loan amount.

A few things to know about 401k loans:

  • Since you’re incurring debt and will need to make monthly payments on the loan, your ability to get a mortgage may be affected.
  • The interest rate on 401k loans is generally about two points above the prime rate. The interest you pay, however, isn’t paid to the company – it goes into your 401k account.
  • Many plans give you only five years to repay the loan. In other words, if you borrow a large amount, the payments could be substantial.
  • If you leave your company, you may be required to pay back the outstanding balance within 60 to 90 days or be forced to take it as a hardship withdrawal. This means you’ll be hit with taxes and penalties on the amount you still owe.
  • If payments are deducted from your paycheck, the principal payments will not be taxed but the interest payments will. Since you’ll be taxed again on withdrawals during retirement, the interest payments will end up being double-taxed.

Sometimes it makes sense to take a loan from your 401k to cover the down payment, like if you’re getting an FHA loan and only need a small down payment. However, a large loan payment could have a big effect on your mortgage qualification.

Consider that a $5,000 401k loan will have a payment of $93 per month (at a 6% interest rate) over five years, while a $25,000 loan will have a payment of $483 per month. The latter payment could seriously hinder your ability to pay the mortgage every month, and the bank will take this into consideration when figuring what you qualify for.

Therefore, it’s wise to run numbers and ask your mortgage broker how such a loan will affect your qualification before you take one out. Conversely, if the amount you need will have too adverse an affect on your qualification, it might make sense to withdraw the down payment amount and pay the taxes and penalties.

 

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