Why You Should Not Use Your 401(k) to Buy a New Home

Buying a home is part of the American dream. Andy Dean Photography/Shutterstock

Buying a home is part of the American dream. Many people look forward to it for years, and when they find an opportunity, they go for it in any way they can. Since cash is harder to come by these days, borrowing money from a 401(k) to buy a new home can suddenly look very appealing.

Many employers offer a 401(k) retirement plan for their employees. Its purpose is to save money for retirement. Employees can contribute to a traditional 401(k) with tax-free money, but will pay taxes on their withdrawals. If an employer offers it, they could contribute to a Roth 401(k) with after-tax money, which enables all withdrawals during retirement to be tax-free.

Generally, if you take withdrawals before turning 59½, you will have a penalty tax of 10 percent charged on the amount withdrawn, plus the regular income tax. The Internal Revenue Service (IRS) does allow withdrawals without penalty before that age under five exceptions.

The Exception of Getting a Downpayment of a First Home

According to HomeBuyer, you can use a maximum of $10,000 from a 401(k) to buy your first home. The 401(k) company can give you the money as cash or as a loan. Not all companies, however, will do this. A bill currently in Congress hopes to increase the size of home loans from 401(k)s to $30,000.

What You Need to Know About a 401(k) Loan

If you take the money as a 401(k) loan, you have to repay it. The plan administrator will determine the interest rate—usually 1–2 percent. No penalty will be applied, and it is considered non-taxable income. However, there are some things you need to know. Until the loan is repaid, you cannot make any more contributions to your retirement plan.

Investopedia adds that you usually have five years to repay the loan. The interest goes into your account and not to the bank. If you go to another job, the repayment period drops to the next time you need to file your taxes, and you may have to pay an additional 10 percent if you are under 59½.

Applying for a hardship withdrawal is likely to be met with a refusal. RamseySolutions says that current 401(k) hardship withdrawal rules require you to prove genuine hardship and show how buying a house will solve that problem.

A 401(k) Loan Is Not Reported to Credit Bureaus

There are two powerful advantages of getting a 401(k) loan. RocketMortgage says that the first is that it does not count as part of your debt-to-credit ratio when seeking to get a mortgage. You will have to report it when you apply for a mortgage. A second advantage is that it will not affect your credit score.

The Negative Aspects of a 401(k) Loan

Here are three reasons why you probably should avoid taking a loan out of your 401(k):

• Reduces Your Retirement Savings Money

The fact that a loan taken out of your 401(k) can put a big dent in your retirement savings should make you think twice about doing it. Since employment is not always stable, you may be unable to make it up. Also, while you cannot make new contributions until the loan is paid off, remember that your employer is not making contributions either. If it takes a few years to repay it, you are missing out on years of contributions and new growth.

• Two out of Three People Over 45 Are Entering Forced Retirement

While it is easy to hope for the best, the truth is that two out of three people between 45 and 74 in retirement were forced out of their jobs, according to LinkedIn. Poor health could also cause you to retire early, which would make it impossible to make up for the lost time in contributions and interest.

• Financial Advisers Do Not Recommend It

Almost any reputable financial advisor will tell you to only use your 401(k) as a last resort. If you have other options to get the money as a first-time home buyer, you should prefer them above taking out a loan against your retirement savings plan.

Possible Options to Borrowing From Your 401(k)

Instead of borrowing money from your 401(k), here are some options that could be better. Although they will take some paperwork, you will not need to interrupt your retirement savings.

• Withdraw Funds From a Roth IRA

Money put into a Roth IRA has already been taxed. As long as you are 59½, you will not pay any taxes on withdrawals. The account must also have been operating longer than five years to get withdrawals without penalties. TheMortgageReport adds that money from a Roth 401(k) will not have a shortened repayment period if you change jobs because the account is not from your employer.

• Zero Down Payment Options

There are two government loans that you may be able to get. If you are a veteran, you can get a zero-down-payment home loan from the Veterans Administration. No private mortgage insurance (PMI) is required, and it offers low interest rates.

The U.S. Department of Agriculture also offers zero-down payments on their home loans. The homes are only available in rural areas, and your income cannot be more than 115 percent of the average household income in the area.

• Low-Down-Payment Options

If you have a low credit score and at least a 3 percent down payment, there are some loans you may be able to get. They include the conventional 97 loans (PMI required), Federal Housing Administration loans (which requires a 3.5 percent down payment with mortgage insurance premium), and Fannie Mae HomeReady and Freddie Mac Home Possible loans.

There is no need to take money out of your 401(k) when you have other sources available for buying a house for the first time. Before you buy a home, talk to a financial advisor to determine your best options.

The Epoch Times copyright © 2023. The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.