Should I Borrow From 401(k) For Down Payment

Piggy BankDuring a recent loan pre-qualification process a mortgage applicant disclosed that he wanted to put 10% down on the purchase using money from his 401(k). We quickly pointed out that this may not be a good idea – considering the impact of taxes, withdrawal penalties and loss of future earnings. Additionally, since this borrower qualified for a FHA loan albeit for a lower amount, it didn’t make financial sense to make such a move.

I certainly can understand the temptation to use money from a 401(k) plan for a home purchase or even using it for emergency purposes. This is especially tempting if you have a decent amount of money in your account and you have recently faced some difficulties. However, I suggest taking a long hard look at this before deciding on a withdrawal. To help in this, MSN Money Central has a good article on this subject which outlines the pro’s and con’s of borrowing against a 401(k) plan:

The pros:

1. There is no credit check.
2. There is a low interest rate.
3. It provides a great return.
4. The interest is tax-sheltered.
5. It’s convenient.

The cons:

1. About that credit check: Of course there isn’t one. You’re not borrowing anything. You’re spending your own money.
2. You’re losing interest. The net effect is that you have less money to invest and to earn interest.
3. It’s not tax-sheltered money anymore. Whether you repay the 401(k) loan out of your salary or from a bank account, those payments are all made back into the 401(k) with after-tax dollars.
4. Unless you repay the loan, it is considered a premature distribution. You would owe federal and state income taxes as well as that 10% penalty if you are under age 59 1/2.
5. The loan isn’t tax deductible. It’s considered a consumer loan, so there is no tax advantage.
6. It affects your psychology toward retirement saving.

While it is up to an individual to decide if they want to make a withdrawal on their 401(k) I personally would not recommend this course of action – certainly not for a home purchase. My main concern is point #6: your psychology towards saving for retirement. I think the moment you tap into your 401(k) it’s easier to do that again and again. Then it just becomes another savings account (very expensive one), but you destroy your ability to save!

Your MoneyThe main reason to not borrow is because there are still so many loan options available to purchase a home. FHA allows you to borrow up to 97% of the home value and allows 3% gifts. So, in essence you can do a 100% loan with little out of pocket money. The FHA loan limits have been recently increased and in many markets this limit is well above the median home price. So it’s not like you can only buy the bottom of the barrel homes with FHA. You can actually buy your dream home.

The better option is therefore for you to work with a mortgage loan professional and make a six or twelve month plan to reposition your credit, income, savings and investments. This effort on your part can help you purchase a home without touching your 401(k). Home prices are not increasing at astronomical levels – so there is no reason why you shouldn’t wait until you’re much better positioned to make a sound purchase. That way you’ll have a home and something for retirement – not just a home.

Loan Approvals Depend Entirely on Income Verification

I’ve written plenty about the importance of having a good credit score and maintaining a clean credit report. From getting a job promotion to finding the right spouse, your credit score can play a much more ubiquitous role than ever before. That was then, but this is now. In today’s changed lending landscape your perfect score doesn’t mean as much as the lenders ability to verify your income! It’s that simple. “Good credit, bad credit, any credit” doesn’t fly anymore. It’s more like “good income, verifiable income, consistent income”!

During the boom years (2002-2006) income verification during the mortgage application process pretty much fell by the wayside. Lenders were not paying too much attention to where you made your money, how you made it and the likelihood of it continuing for the next three years. They simply looked at your credit score and “assumed” you’d be able to make the monthly payment. I know that is somewhat of an exaggeration, but that is the exact kind of mindset lenders had and in many cases the root of the current credit problem.

Now that enlightenment has reached everyone from Alan Greenspan to hedge fund accountants, lenders have finally accepted the fact that borrowers need to be able to make the monthly payment. This realization is turning lenders old fashioned grumps demanding to see proof that your employer exists, your check is real and that you indeed have a certain career stability. This means if you fill out a mortgage application today you will be asked detailed questions regarding your income and employment and depending on your exact situation the level of scrutiny can vary significantly.

For regular full time salaried borrowers receiving W2′s at the end of the year, the requirements are minimal. All you need to do is furnish a few recent pay-stubs and a copy of your most recent W2 and you’re essentially good to go. If you receive more than 25% of your income in the form of commission then you may need to furnish two years of tax returns. The clunker on these is any un-reimbursed employee expenses that reduced income. That can make your effective earnings lower and decrease the amount you can afford. Additionally, a decreasing commission income trend will also play a factor in the under writing decision.

Life is most difficult for the self employed borrower with the smart accountant. Don’t forget that self-employed also includes those who receive 1099 income as well – so its not just a business owner. Two years of personal tax returns is universally required in these cases but I am starting to see requests for two years of business tax returns as well. Of course, the tax returns always show a very low income and unfortunately there is very little that can be done to account for this lowered income. This is because the lender will make the loan decision on the taxable income – and in many cases the income is simply too low. There are some things which can be added back to the income but only very much. The five or six times I’ve gone through this process for a self employed borrower I haven’t been able to add a whole bunch back to their income.

As you can see, it’s a different world out there. It’s still very important to have good credit and all the other things like down payment, but income verification is increasingly more important. The only real way to make income less important in the credit evaluation process is to put more money down. If you are able to put 25% or more down then in many cases I’ve seen the income verification requirements reduced. However, not everyone is in a position to make a higher down payment.

Short Sales: Four Tips to Get You an Accepted Offer

Short sales and bank owned properties (REO) seem to be in hot demand these days in the Phoenix area. Why shouldn’t they be? For many, these properties can make perfect sense plus there are lots of them to go around. According to Phoenix area real estate agent Jonathan Dalton there are currently over 5000 short sale homes listed in the Phoenix MLS and over 4700 REO’s. This represents almost 20% of homes currently on the market.

I’m not suggesting you should purchase short sales or bank owned properties, but if you should decide on making an offer here are four things you need to know:

1. Short Sales Want Quick Closes: While the actual short sale approval process may take several weeks, once the sale has been approved, the bank typically will go with the buyer who is able to close very quickly. Quick here means ten days or less. Hence, they give priority to cash offers if acceptable but if there are none, then they will accept the next quick close.

2. Obtain Credit Approval Before Making An Offer: Since you are more likely to have an accepted offer if you can close quick it is important that you as the buyer work with a lender that allows “credit only” approvals. This means you will have signed the initial loan disclosures, reviewed all loan parameters and decided on your loan. Additionally the lender will have collected all the necessary documents and provided a full underwriting approval. The only piece remaining at this point would be the property appraisal.

3. Obtain Commitment Letter From Lender: While getting pre-approved and submitting an LSR with your offer is important, I suggest you obtain a commitment letter from your lender. A commitment letter indicates that you have indeed been approved for the loan and are 100% able to finance the purchase. Lenders will typically only issue a commitment letter once the loan has been approved by underwriting (point 2).

4. Line Up Appraisal and Home Inspection: As I mentioned earlier, the bank will accept offers that can close within 10 days. This means you need to have a home inspector lined up to inspect and approve the property to your satisfaction. Additionally, your lender needs to have an appraiser ready to go in on very short notice. Time is of the essence here and you need to be prepared.

It seems like most the borrowers I’ve worked with recently are purchasing bank owned or short sale properties. It’s not that the loan process is any different than before, it’s just that there are enough “curve balls” to throw the process off track. That is why your lender needs understand your situation exactly. This is especially the case given tighter lending standards and the inventory of homes currently on the market.

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