When you’re searching for a home, coming up with a large enough down payment can be challenging.
If you look through your assets and see your 401k growing, that balance might tempt you to use the money to buy a house. But using 401k for down payment funds can have long-term consequences.
The high cost of home ownership
According to data released by the National Association of Realtors, the median price of a home in the United States is $240,200.
Potential buyers need at least 20 percent as a down payment, or they are subject to private mortgage insurance (PMI) — and PMI can add a significant amount to your mortgage.
But most people don’t have $48,000 sitting in a bank account. In fact, the majority of homeowners only put down 14 percent of the home’s sale price. That means buyers are adding on hundreds or even thousands of dollars with PMI.
Using 401k for down payment funds
In contrast, people tend to have a lot more money saved for retirement than they have set aside for a home. With regular contributions and employer matches, people have larger 401ks than ever — the average American has a balance of $91,300.
Having that much money sitting there could make anyone think about emptying it out for a house fund.
There are two ways people can use their 401k to buy a home: They either cash out their 401k completely, or they take out a 401k loan. But according to Brandon Hayes, a CFP and practicing financial planner, neither option is a good idea.
“The opportunity cost that clients miss out from not having their 401k fully invested in the market can have negative consequences long-term,” says Hayes. “If you have less money working for you in the market, then you may miss out on market upswings and positive returns.”
Cashing out a 401k
You can cash out your 401k and take the full amount to use as a down payment. The catch? You have to pay a penalty. You will lose 10 percent of the amount withdrawn, plus you will owe income tax on the amount, too. It can end up costing you thousands of dollars.
For example, if you need $25,000 for your down payment and are in the 25 percent tax bracket, the IRS will charge you $6,250 in taxes and an additional $2,500 as an early withdrawal penalty. That means you will empty your account of nearly $34,000 to get your $25,000 down payment.
Cashing out your 401k for a down payment can negatively impact your retirement and your overall finances.
Borrowing from 401k for down payment costs
Another option is to take out a 401k loan for home purchase payments. You can withdraw up to $50,000 or half the value of the account, whichever is less. This approach is less costly than cashing it out since you will not owe a penalty.
However, there are many drawbacks to this approach. Mortgage companies treat your 401k loan as a regular debt, so it can impact your credit score and whether or not you get approved for a home loan.
Further, you need to pay the loan back with interest. You only have a few years to pay it back, so if you take out a large amount, your monthly payments can be big.
Finally, if you leave your company for a new job, you may be required to pay back the full loan balance within 60 to 90 days of your last day. If you cannot pay it all back within that time frame, the government treats it like an early withdrawal and you’ll be subject to the penalties and taxes of cashing it out.
The impact on your future
If you’ve thought about using 401k for home purchase costs, the consequences can be substantial. Whether you cash out your retirement fund or take a loan, you will deplete your account.
Even if you dedicate yourself to saving diligently afterward, you miss out on the compound interest you would have earned on the money. Withdrawing that money can be a temporary solution that can cause issues later on.
“Taking out a 401k loan to purchase a home may increase the chance for the client to end up in a home they can’t afford,” says Hayes.
“If you can’t afford to put enough money down through proper savings then maybe homeownership isn’t right for you at that time. Let your 401k remain a retirement investment vehicle and not a source to fund your home purchase.”
If you’re anxious to buy a home but don’t have the down payment you need, think long and hard about using 401k for down payment costs.
It will cost you thousands upfront and can significantly impact your retirement later on. Instead of using a 401k loan for down payment funds, be patient, lower your expenses, and build your savings until you can afford your dream home.