Fun fact: Live in a big enough city and you’ll likely find it’s cheaper to buy a home than rent one — so long as you put enough money down, of course.
General rule of thumb stipulates a 20% down payment. Plus, you’ll need to cover closing costs, which include attorney fees, at least a few months of property taxes and a year’s worth of homeowners insurance. That’s a serious savings goal, but there are ways to expedite your house hunt.
One option involves tapping into a 401(k). Now, most financial experts would interrupt us right here and say that’s an absolutely terrible idea — and, in most cases, it is. Those funds are already designated for something, namely, your retirement. Plus, there are some serious consequences associated with tapping them.
There are a few times, however, where the move is … well, let’s just say, not the worst thing ever. And some people are going to pull funds out of their 401(k)s anyway. So, in the interest of these individuals, here are five things to know.
1. There are two ways of tapping your 401(k) for a down payment on a home.
You can withdraw the money via what’s known as a hardship distribution, so long as your plan allows. Hardship withdrawals aren’t required by law, so some 401(k)s don’t permit them. If your plan does, you’ll still need to demonstrate an “immediate and heavy” need for the money. That’s how the IRS puts it at least. Per its website, it recognizes the purchase of a principal residence as “immediate and heavy." Hardship withdrawals aren’t capped, meaning you can take out as much money as you need for the expense.
Alternately, you can borrow money from your 401(k). Again, that’s only if your plan allows. Sponsors need to meet certain requirements, says Certified Financial Planner Julio Hoyos. For instance, the loan must carry a reasonable interest rate. Beyond that, borrowing restrictions apply. The loan can’t exceed the lesser of 50% or $50,000 of the account’s vested value, though if your account balance is below $10,000, all those funds are fair game.
2. There are serious financial ramifications associated with both options.
If you withdraw the money, it’s classified as taxable income. And, if you’re under 59-and-a-half, the IRS tacks on a 10% early withdrawal penalty. Borrowing the money lets you skip the taxes and penalty, but that’s doesn’t mean there are zero drawbacks associated with tapping the funds.
You’ll have to make loan payments, including interest, which could affect your chances of qualifying for a mortgage, says Carl Holubowich, a Certified Financial Planner with Armstrong, Fleming and Moore, Inc.
And while that interest gets paid into your 401(k) account, “the loss of earnings growth could leave a gap in your retirement egg,” he says.“You also repay the loan with after-tax dollars, so you pay taxes on that money again when you take withdrawals in retirement.”
Oh, yeah, and one more thing …
3. ‘Borrowing’ becomes ‘withdrawing’ if you leave your job and can’t readily repay the loan.
A 401(k) home loan is generally paid back over a five- to 15-year timeframe — unless you quit or lose your job. Then the balance comes due and you’ll have 60 to 90 days to pay it off, Holubowich says. If you can’t, well, the loan is considered taxable income and, again if you’re under 59-and-a-half, that 10% early withdrawal penalty also kicks in.
4. There’s a way for first-time homebuyers to avoid an early withdrawal penalty.
First-time homebuyers can withdraw up to $10,000 from a traditional IRA without incurring the 10% early withdrawal penalty. Meanwhile, a 401(k) plan must allow in-service rollovers, says Holubowich. You can also rollover a 401(k) from an old employer. See where we’re going with this? If you roll over the funds from your 401(k) into a traditional IRA, then withdraw the funds to buy your first home (or at least your first home in two years, as “first-time homebuyer” is defined), you won’t have to pay that 10% penalty.
“Note that you will still owe income taxes on the withdrawal,” Holubowich says.
5. You don’t need a 20% down payment to buy a home.
You can get a conventional mortgage with as little as 5% down and FHA loans require as little as a 3.5% down payment. You’ll have to pay private mortgage insurance (PMI — which is different than mortgage protection insurance, by the way) and a lower down payment means more interest over the life of the loan, but putting down less than 20% is an option. You don’t have to go straight for the 401(k). You also don’t need to buy a home right this very second.
“Sometimes the best choice is to defer buying until you have saved enough outside of the plan to put towards a down payment,” Holubowich says.
If you’re itching to buy a home, you expedite saving while renting by negotiating with your landlord, getting a roommate or setting up a mortgage down payment fund. You can also use the time to learn more about the different kinds of mortgages that are available, and what to understand before applying. We’ve got a few more ideas on how to beef up your savings here.