During 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!
The 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.