Understand the pros and cons of using 401(k) for down payment

Q

My husband and I are trying to scrape together enough money for a down payment on our first home. Because we live in an expensive real estate market, we need to be creative and consider all our potential resources. Would it be OK if we borrowed from our 401(k)s?

A

How exciting that you’re buying your first home! I know how hard it can be to come up with a down payment in an expensive market, so this is a great question.

The traditional financial advice has long been, “Never take an early withdrawal from retirement savings,” and I generally agree. One exception, however, might be exactly the situation you describe. Why? For two reasons. First, because you’re taking a loan rather than a permanent withdrawal. Second, because you’re using the money to buy a first home, which can be a challenging — but ultimately worthwhile — financial goal.

That said, you need to proceed with caution. A study by TIAA found that nearly a third of Americans who participate in a retirement plan have taken out a loan from it, and 44% regretted it. So, if you want to borrow from your 401(k) without regret, it’s best to understand how such loans work, as well as the benefits and risks involved.

The basics

First, not all 401(k) plans allow loans. Even if yours does, every 401(k) plan limits how much you can borrow: one-half of the vested value of your account or a maximum of $50,000, whichever is less. If both you and your spouse have $100,000 or more in separate accounts, you’re eligible to borrow $50,000 each, for a total of $100,000 — a big chunk toward a down payment.

The repayment period is typically five years, although that can vary by plan and may not apply if the loan is used to purchase a home. Repayment options usually include regular deductions from your paycheck or a lump sum by a specific date, and there’s no penalty for repaying the loan early.

In general, I recommend you pay back the entire amount as soon as possible, preferably in three years or less. No matter which option or time frame you choose, it’s important to create a repayment schedule and stick to it.

Revisit your budget and make this a line item. If you miss even one payment, the loan could be recategorized by the IRS as a “distribution,” which means you would have to pay federal income tax on the loan amount, plus a 10% early withdrawal penalty if you’re under age 59 1/2.

The potential benefits

One of the best parts of borrowing from your 401(k) is you don’t have to go through the lengthy process of applying for a loan. There are no credit checks, and you can usually place a call or make a quick visit to your 401(k) provider’s website to secure the loan and have a check in hand within a week.

The other upside is that principal and interest on the loan are paid to your own account. So a 401(k) loan effectively becomes an interest-free loan — provided you repay it on time.

The potential risks

One of the biggest risks of borrowing from your 401(k) is you’re usually required to repay the loan immediately if you lose your job. Depending on your plan, this might be at termination or within 60 days. If there’s a chance your job is at risk and you’d be unable to repay the loan on such short notice, I’d caution against borrowing from your 401(k).

There are also considerable long-term risks to consider. While borrowing from a 401(k) may allow you to buy your first home, it still diminishes your retirement assets. By taking out a loan, you’ll lose the tax-deferred growth on that part of your savings until the funds are put back.

In addition, some plans don’t allow you to make new contributions during the repayment period. This means you could miss out on adding to your savings, the earnings from such contributions and any matching contributions offered by your employer — which could derail your retirement plans. So if you’re already behind on your retirement savings, taking out a loan is probably a bad idea.

Final thoughts

As a rule of thumb, you want to build up your retirement assets, not deplete them. Therefore, resist the temptation to borrow from your 401(k) to pay for anything other than a down payment.

That said, a short-term loan from a 401(k) to buy a house can make sense in some cases, especially if your job is secure, you’re generally on track with your retirement savings and you’re buying into what you believe is a healthy real estate market. Just be sure you have enough of a cash cushion to cover contingencies. You don’t want to be so house-poor that you can’t properly maintain the property or respond to an emergency.

If you do decide to take out a short-term loan for your down payment, make sure the size of the loan payment doesn’t impede your ability to keep contributing to your 401(k), if your plan allows it. Even if you can’t afford the maximum contribution, put away at least enough to capture the company match. You don’t want to walk away from free money.•

Carrie Schwab-Pomerantz, Certified Financial Planner, is president of the Charles Schwab Foundation and author of “The Charles Schwab Guide to Finances After Fifty.” You can email Carrie at askcarrie@schwab.com. Opinions expressed are those of the author.

© 2019 Charles Schwab & Co. Inc., Member SIPC

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