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The short version

  • You can technically use your 401(k) on a down payment by either withdrawing funds or borrowing money. However, both options come with fees, penalties, or other costs that need to be considered.
  • First-time homebuyers should look into down payment assistance programs before tapping into their retirement plans.
  • If you're certain that you want to use retirement funds for a home down payment, your IRA will generally be a better option than your 401(k).

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Can I use my 401(k) to buy a home?

Your 401(k) is a special savings account earmarked for retirement. That means that withdrawals are generally only allowed by the IRS after you turn 59 ½, or before 55 if you’ve left or lost your job.

However, if you're looking to use your 401(k) to buy a home, there are two ways to get funds out of your plan before age 59 ½:

  1. You can borrow money from your 401(k) account which will need to be repaid with interest, or

  2. You can withdraw funds which will incur a 10% penalty and are fully taxable at your current tax rate.

A loan is easier to do than a withdrawal for the purpose of a home down payment. That’s because to qualify to withdraw funds early from your 401(k), you need to show evidence of a financial hardship (buying a house is typically not considered a financial hardship).

That being said, there are both advantages and drawbacks associated with using money from your 401(k) to buy a home.

Why you might consider using your 401(k) for a down payment

  • Buy sooner and start building home equity instead of renting. Owning a home is still the American dream. If you’ve been delaying a first-time home purchase because you can’t seem to get the full down payment saved, borrowing from your 401(k) may be the temporary boost you really need.

  • Low interest. The interest rate on 401(k) loans is typically 1-2% over the prime rate, which is an attractive rate for personal loans and much less than credit card debt.

  • 401(k) withdrawals do not need to be repaid. You pay the penalty off the top and you get your funds.

  • A 401(k) loan will likely not negatively affect your mortgage loan approval because it's not usually counted in your debt-to-income ratio. And since the loans are not reported to credit bureaus, the loan won’t affect your credit score.

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Drawbacks to using your 401(k) for a down payment

❌ You may pay a penalty. 401(k) withdrawals are automatically docked a 10% penalty. 401(k) loans are penalty-free. However if you leave your current employer or are laid off while you have an outstanding loan balance, you will need to repay the loan by that year’s tax filing date and may incur a penalty.

❌ The loan must be paid back with interest. Typically, the interest rate is prime plus 1-2% and the payback period is five years. The problem is that with a new house payment, regular home maintenance expenses and a possible home repair issue, it may be difficult to pay back the loan.

❌ You must involve your employer as the company needs to approve a 401(k) loan. This may or may not matter to you but for some, it becomes a privacy issue.

❌ Penalties and taxes. A withdrawal from your 401(k) is expensive! Let’s say you take out $25,000. You'll be charged a $2,500 (10%) early withdrawal penalty. Plus, you’ll have to pay income tax on the amount you withdraw — this will likely run you $5,000 to $7,000, depending on your tax bracket. That means that your $25,000 is effectively reduced to at best $17,500.

❌ You may not be able to make 401(k) contributions (nor your employer) while you have an outstanding loan. In the meantime, you could miss out on free funds if your employer has a matching program.

❌ Removing funds reduces your retirement nest egg. That includes the compounding interest you could get from staying invested. You are borrowing from your future if you take out a loan and a withdrawal removes the opportunity for the money you could have left in your account to grow.

As you can probably tell by now, using your 401(k) for a down payment on your first home should not be your first option. The cons far outweigh the pros. You’re essentially stealing from your retirement future to fund today’s expenses. So what else can you do to help fund your down payment? Let’s look at a few alternatives.

Best alternative ways to fund a home down payment

Now that we’ve established that taking a withdrawal or borrowing money from your 401(k) for a home purchase down payment is not advisable by most experts, here are four alternatives to investigate before you decide to borrow or withdraw from your 401(k).

Consider using your IRA account

Unlike a 401(k), an IRA has a specific provision for first-time homebuyers which allows a withdrawal of up to $10,000 without a 10% penalty (normally, any amount over $10,000 will incur the penalty). Of course, you’ll still have to pay federal and state income tax on the amount you withdraw from your traditional IRA.

Some Roth IRAs even have a provision that allows account owners to withdraw up to $10,000 tax free if the money is expressly used to purchase a home as a first-time home buyer.

More: Withdrawing from a traditional IRA: rules & regulations

Look into DPA (down payment assistance) programs available in your state.

These programs offer low-interest loans — and even free money in the form of grants — to help first time homebuyers with their down payment and/or closing costs.

You have to qualify for these programs and eligibility rules vary. In general, to qualify for down payment assistance:

  • You must not have owned a home in the past three years, and
  • You must have a steady income, a credit score of 620 or higher and an acceptable debt-to-income ratio.

In addition to the above, you may be required to take a class.

There are several types of down payment assistance programs that you can apply for:

  1. Grants – These are usually government backed programs that require you to stay in the home for a certain number of years. If you sell before the term, you will need to pay back the grant.
  2. Forgivable Loans – Similar to a grant, but structured as a second mortgage, these loans do not need to be repaid unless you sell before the agreed-to number of years.
  3. Deferred Down Payment Loans – These loans give you money to buy the home, no payments while you own it and you pay it back when you sell.

Find mortgage lenders who specialize in helping first-time home buyers

As the home buyer, you choose your mortgage lender. It’s easy to compare interest rates among lenders and go with the one who offers you the lowest rate.. But there are other factors to consider as well.

Some lenders specialize in helping first-time home buyers. These lenders have a lot of experience with DPAs and other programs. Not all lenders work with these initiatives because it’s extra work for them.

As an agent, I send all my first-time home buyer clients to a Guild Mortgage loan officer. She knows everything about all the available DPAs in the state. And she works relentlessly to get every penny she can for my clients. Not only that, I’ve seen her provide additional closing help from her company when the numbers were very tight. Yes — some lenders even offer down payment or closing cost help for first time home buyers!

It pays to do your due diligence when looking for a mortgage company and loan officer. Like anything else, there are great ones and not so good ones. Working with a person face-to-face instead of an online lender can be particularly important as a first-time home buyer where the process is all new to you.

More: How to lower your real estate closing costs

Ask a relative or friend for a gift

It's tough saving money for a down payment and closing costs. Sometimes it makes sense to ask for help. Many mortgage companies will allow you to use gifted money to cover part of all of your down payment and closing costs.

During the loan application process, where you provide all your financial details, you need to disclose the source of these funds and properly document that source with a gift letter from your friend or relative. But don’t let that deter you. It’s done all the time. And maybe your relative or friend has the funds and would like to help you out.

The takeaway: should you use your 401(k) for a down payment on a home?

Based on the high cost (penalties and taxes), coupled with the lost opportunity for growth of your retirement nest egg, withdrawing funds from your 401(k) should not be your first option when pulling together a down payment on a home.

Borrowing money from your 401(k) beats withdrawing from it. But it could still be costly since you may not be able to contribute to your plan while the loan is outstanding. You’ll also need to pay back the loan. And that may be difficult to fin into your budget on top of the other costs of owning a home.

Instead, look into Down Payment Assistance programs, talk to a mortgage lender who works with first-time buyers and don’t be shy about asking your family or friends for help if that’s available to you. And if you do want to tap into your long-term savings, your IRA would be a much less risky route than your 401(k).

Some guides to help you buy your first home::

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Ruth Lyons Freelance Contributor

Ruth Lyon is a freelance contributor for Moneywise.

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