Using your 401(k) to buy a house: Allowed but not recommended

You likely can’t use your 401(k) to buy a house flat-out, since there are limits to the amount of money you can take out.

However, it’s possible to use your 401(k) to cover the down payment and closing costs on a home purchase.

We’ll say right off the bat that using your 401(k) to purchase a home typically isn’t the best method.

There are plenty of alternatives to your 401(k) to get cash for a down payment — ones that won’t have the same long-term ramifications as taking money from your retirement savings.

How to use a 401(k) loan to buy a house

A 401(k) loan is the preferred method if you need to tap your retirement savings to buy a house. That’s because there’s a much lower cost associated with a 401(k) loan than a withdrawal.

A couple other perks include:

• A 401(k) loan is usually not counted in your debt-to-income ratio, so it won’t hurt your chances of mortgage qualifying
• 401(k) loans aren’t reported to credit bureaus, so applying for one won’t harm your credit score

Unlike a 401(k) withdrawal, a 401(k) loan is not subject to a 10% early withdrawal penalty. And the money you receive will not be taxed as income.

The rules for using a 401(k) loan to buy a house are as follows:

• Your employer must allow 401(k) loans as part of its retirement plan
• The maximum loan amount is 50% of your vested 401(k) balance or $50,000, whichever is less
• The loan must be paid back with interest (typically the prime rate plus 1-2%), on a schedule you agreed to by you and your 401(k) provider
• Typically, you cannot make 401(k) contributions while you have an outstanding 401(k) loan

401(k) loans typically need to be paid back over 5 years.

However, when the money is used to purchase a home, you’re usually allowed to pay it back over a longer period of time. Rules vary by 401(k) company, so check with yours to learn more.

Drawbacks to 401(k) loans for home buying

The catch is, while you’re paying back the 401(k) loan, you usually can’t make contributions to your retirement account. And that means your employer won’t be matching contributions, either.

So all told, you could miss out on 5 years or more of retirement contributions — which will likely make a big dent is your savings later in life.

In addition, if you leave your current company or are laid off while you have an outstanding 401(k) loan, the repayment period shortens. In that case, you’ll have to repay the loan by that year’s tax filing date.

For example, if you take out a 401(k) loan on October 1, 2020, then leave your job on December 1, 2020, your entire loan would need to be repaid by April 15, 2021.

If your 401(k) loan is not repaid by the date it’s due, the remaining balance is treated as a 401(k) withdrawal. So it will likely be taxed as income and subject to a 10% penalty.

Using a 401(k) withdrawal to buy a house

401(k) withdrawals are generally not recommended as a means to buy a house, because they’re subject to steep fees and penalties that don’t apply to 401(k) loans.

If you take a 401(k) withdrawal before age 59 ½, you’ll have to pay:

• A 10% “early withdrawal” penalty on the funds removed
• Income tax on the funds removed

For example, say you withdraw $20,000 from your 401(k) to cover your down payment and closing costs.

• You’ll be charged a $2,000 early withdrawal penalty
• And you’ll have to pay income tax on the $20K, which likely comes out to around $4,000-$6,000

That’s around $8,000 gone from your retirement savings, on top of the initial withdrawal.

The standard rules for 401(k) withdrawals are as follows:

• Most 401(k) plans only allow withdrawals in cases of financial “hardship”
• However, taking a 401(k) withdrawal to buy a house is usually acceptable
• You can only withdraw as much money as is necessary to cover your immediate need
• The money does not have to be repaid

Coronavirus update:

Should you use your 401(k) as a first time home buyer?

Home prices just keep rising — which means saving the required down payment to buy your first house can be really tough.

But as a first time home buyer, taking money from your 401(k) to buy a home is likely not the best option.

First time home buyers are often at a key age for making retirement contributions. The more money you put in when you’re young, the longer it has to accrue interest.

By taking money out of your 401(k) to buy your first home, you can seriously reduce the amount in your savings when you’re ready to retire.

For example:

• Say you have $30,000 in your 401(k) at age 30
• After 25 years at 7% interest, that $20K will have grown to $162,800
• But you take out $10,000 to make a down payment on your first home
• Now, your 401(k) has $20,000 in it at age 30
• After 25 years at 7% interest, it will have grown to $108,500
• So $10,000 withdrawn now means $54,000 less in your 401(k) at retirement

This isn’t to say a 401(k) loan or withdrawal is always the worst option.

But before you turn to your retirement savings, consider all the other routes available for first-timers (or repeat buyers) to purchase a home.

Alternatives to using your 401(k) to buy a house

Many homebuyers assume they need a 20% down payment, which can make it seem nearly impossible to save enough cash to buy a house.

But home buyers no longer need 20% down.

Do you qualify for a mortgage without 401(k) funds?

With such a wide range of mortgage options and down payment assistance on the market, most people simply don’t need to tap their 401(k) in order to purchase a home.

On top of that, today’s low mortgage rates increase your home buying power by reducing monthly payments. It’s easier to afford a home than ever before.

Before taking money out of retirement, find out whether you qualify for a mortgage based on your current savings. You might be surprised.