Saving up money for a down payment and closing costs to buy a house is one of the basic requirements in order to qualify for a home loan. It can be a tedious process, especially for first-time home buyers.
However, lenders do allow access to a retirement account as a legitimate source of cash from a 401k or an individual retirement account (IRA). But while those funds are available and are easily accessed by a borrower, should those accounts be used for a down payment and closing costs?
Many employees contribute to a 401k, which is sometimes stylized as 401(k) because of the tax code that regulates these accounts. Most 401k plans allow an employee to take out a loan for certain purposes. Most 401k programs that allow for borrowing will allow an employee to use the 401k loan to buy a house.
Every 401k plan is different, so check with your HR department about the specifics of your 401k program. Generally, employees can borrow up to 50 percent of their vested balance. Sometimes a dollar amount cap is placed on the loan.
For example, if your 401k account balance is $80,000 and you’re fully vested, you may be able to borrow 50 percent of that amount, or $40,000. This would be a nice down payment on a home.
The loan terms will vary and there is interest charged on the loan. But rates are relatively low and most loans require the loan to be paid off in five years or less. You are basically borrowing from yourself, so as far as loans go, a 401k loan is one of the best options.
The 401k plan administrator may want to see a sales contract or other proof of what the funds will be used for.
The key is to know the limits on the 401k loan well before you begin shopping for a house. This could be a simple as a short call to your HR department. Getting a 401k loan from an employer can take up to 30 days, sometimes more, before the funds are disbursed.
The mortgage lender will want to see complete documentation of the 401k loan including loan terms and the loan amount. The lender will also want proof the funds were transferred into one of your personal checking or savings accounts so that it’s readily available when you are ready to close the mortgage loan.
Borrowing From Your 401k Doesn’t Count Against Your DTI
The employer will set up a payment plan. This may involve deductions from paychecks or a requirement that you make monthly payments to the account.
Even though the 401k loan is a new monthly obligation, lenders don’t count that obligation against you when analyzing your debt-to-income ratio. The lender does not consider the payment the same way as it would a car payment or student loan payment. So, if your debt-to-income ratio is already high, you don’t need to worry that your 401k loan payment will push you over the edge.
The lender will, however, deduct the available balance of your 401k loan by the amount of money you borrowed. So if you’re short on cash reserves, you might think twice before borrowing from your retirement savings; some loan types require 2 months of housing payment reserves after closing.
Borrowing From Your IRA
An individual retirement account, or an IRA, is also a source for cash needed to close. You can borrow up to $10,000 from a traditional IRA, or $20,000 for a married couple. As long as you pay the funds back within 120 days, the disbursement is tax and penalty-free. If this is your first home, you can use the funds from an IRA and not have to pay any taxes or early withdrawal penalty. Obtaining a loan from an IRA is really less of a loan but instead a temporary withdrawal.
There are minor differences between a traditional and a Roth IRA. With a Roth, withdrawals are not subject to income tax or early withdrawal penalties by the IRS.
Is Borrowing from a 401k or IRA a Good Idea or Bad?
Because you’re basically loan money to yourself, borrowing from your 401k can be one of your best options.
Obtaining a loan from a 401k account or tapping into an existing IRA fund is a relatively simple process and lenders accept both as proper sources to be used as a down payment and closing costs. The interest rates are low for a 401k loan and the payments are often automatically deducted from the employee’s paycheck, with each payment replenishing the retirement account.
Yet there are some considerations with either choice. The primary one is once your funds are withdrawn and used to buy a house, you’re transferring equity from a retirement fund into home equity. You’re reducing the amounts in your retirement account and lose interest and dividends on the amounts withdrawn.
For example, if you have a 401k balance of $100,000 all invested in a mutual fund that’s giving you a 3.00 percent return on your investment, once you withdraw $50,000, that withdrawal is no longer paying any dividends as they’re removed from your investment pool.
If you pull out money from an IRA the very same thing occurs: your funds may be losing valuable interest and dividend income. On the other hand, if the markets are tanking and you withdraw funds from your 401k or IRA account for a home purchase, you could come out ahead.
And don’t forget about the penalties applied if an IRA isn’t replenished as required. You may be subject to a 10 percent early withdrawal penalty in addition to the income taxes on the amount disbursed. If you have a 401k loan from your employer and you switch employers, the previous employer can require repayment upon termination.
If you’re saving for your retirement, that’s a good thing. And your retirement funds may indeed be a convenient, inexpensive source of cash to close and make homeownership a reality. But don’t tap into either without evaluating all possibilities and make sure you speak with a financial planner to discuss the impact of a 401k loan on your mortgage application and your retirement plan.