Should you borrow a downpayment from your 401(k)?
Mortgage underwriting has gotten a lot stricter since the subprime meltdown, and it's fairly difficult to get approved for conventional financing with less than 20 percent down. So how about borrowing the downpayment from your 401(k)?
Coming up with a downpayment is considered by many the greatest roadblock to getting a mortgage and buying a home. That makes sense if you consider that the average price of a home in the U.S. in February 2010 was $290,900, making an average 20 percent downpayment $58,180. If you put $500 a month into a typical savings account paying 2 percent, it would take nine years to come up with that downpayment! By then, the average home may be even more expensive. Then there are closing costs to consider -- typically 2 percent or 3 percent of the sales price. That's another $8,727.
If you want to take advantage of the buyer's market (cheap real estate and low mortgage rates), you may be able to borrow up to $50,000 from your 401(k) account.
How borrowing from your 401(k) works
If your employer allows you to borrow from your 401(k) plan (most do), you can take the lesser of 50 percent of your vested balance or $50,000. You are typically granted up to five years to pay the loan off, unless you are borrowing the downpayment for your first home; in that case, you get more time.
You have to pay interest on the loan, but you are borrowing from yourself, so you're paying interest to yourself. Getting the loan is relatively easy; you just have to complete a short form or make a phone call.
Is borrowing from your 401(k) a good idea?
That depends. First off, you forgo the earnings on that money while it's not in your account. You repay it with after-tax dollars, so you lose some tax deferral advantages. The biggest risk with borrowing against your 401(k) is that if you lose your job or change employers, you have to repay the loan in as little as 60 days. Otherwise it is treated as an early withdrawal and subjected to the tax on ordinary income plus a 10 percent penalty. On a $50,000 withdrawal, that's a $5,000 penalty plus $12,500 in taxes at 25 percent. Pricey!
If borrowing from your 401(k) keeps you from making your normal contributions, your cost increases substantially, and if you miss out on employer matching contributions, the loan could get extremely expensive. Yet if you can continue making your regular contributions while repaying the loan, you aren't losing much. If you aren't paying mortgage insurance, you may be able to take advantage of property appreciation by buying sooner rather than later (assuming that the real estate market shakes off its doldrums and resumes normal appreciation, which HUD defines at 4 percent). Assuming that you'd otherwise have mortgage insurance in force for five years, you'd be paying about 1 percent per year (ballpark that at $10,000 for five years). Assuming 4 percent annual property appreciation on a $290,900 home, in five years that's over $60,000.
You have a few alternatives to saving for the next decade before you can buy a home or risk your retirement. One is to look into an FHA mortgage. You only have to put 3.5 percent down, which is $10,182 (if you're buying a home worth $290,900). You'd also have to pay an initial and an annual mortgage insurance premium, but they can be rolled into the new home loan. Your other option is to buy a home with 5 percent or 10 percent down (cutting the savings time to 2.25 to 4.5 years), and pay monthly mortgage insurance (MI). Keep in mind that you'll need excellent credit scores to qualify for MI; one major mortgage insurer requires minimum scores ranging from 680 to 740, depending on the property type and use. You can also get the seller to pay your closing costs and save some time. The third option is to apply for down-payment assistance (in most cases, you need to be a first-time homebuyer and meet income eligibility guidelines). The fourth option is to buy a VA or USDA mortgage, which requires no down payment.
If borrowing from your 401(k) saves you from paying mortgage insurance, if you are confident that you'll be with your employer long enough to repay the loan and if you earn enough to repay the loan and the mortgage while keeping up your retirement contributions, your decision to borrow your downpayment from your 401(k) should probably be a "yes."
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.