In order to determine whether or not taking out a 401k loan for a down payment on a big ticket item like a house, we must first figure out what it is in the first place!
What is a 401k Loan?
A 401k loan is essentially money that you can borrow from your own retirement funds under a specific set of stipulations. Here are a few highlights:
- You can typically borrow the lesser of 50% of your portfolio value or $100,000.
- Interest rates are typically relatively low and often fall close to +1% above the current prime rate.
- Terms vary, but are often up to 60 months for a normal loan and up to 180 months if the money is for your primary residence.
- Payments are often deducted straight from your paycheck every pay period on an after-tax basis.
- Typically small fees to start the loan process as well as quarterly maintenance fees.
- Double tax on loan amounts (see below)
- Obligated to pay in full if you leave your employer or get fired!
Most of the time when you consider your 401k you are thinking that the money should and cannot be touched until retirement in order to secure the most money possible. Most of the time, you would be right! However, there are some neat things about a loan like this that might be helpful to you in certain situations. Because you already “own the money” you are essentially becoming both the lender and the borrower of the money which changes the game a little bit from a traditional loan.
On the one hand, the interest that you are paying is actually going back to yourself and effectively results in extra contributions for your retirement fund!
On the other hand though, the compounded interest that you could be earning on this money if it remained safely in the account usually cancels out this benefit and often leaves you with a net loss on your overall investment growth. Also, as noted above, you are actually double taxed on the loan amounts because repayment of the loan comes out of your check after-tax and then you will be paying income tax on the disbursements during retirement. Depending on the situation, your credit score, and other variables it may or may not make a huge impact on the big picture.
How is it Different from a Withdrawal?
A withdrawal from your 401k is the more insidious option that most people are referring to when they tell you not to take any money from your account before retirement. There are a slew of potential negative repercussions for this type of transaction such as:
- The withdrawal is taxed like normal income.
- You normally have to pay a 10% early distribution tax penalty (there are exceptions).
As you can see, this option is much “simpler” in that once you withdraw the money and take the tax hit, there really aren’t any more hassles or strings attached. The cost of this simplicity is obviously the big 10% penalty and the extra taxable income. What if that withdrawal bumped up you into the next tax bracket? This could have far-ranging implications for your tax situation in the year that you took the cash.
Also missing from the withdrawal option is the fact that you’re really under no obligation to pay back the amount that you take. With the 401k loan at least you know that the money will be returned (plus a little extra!) at the end of your repayment terms. Unless you are very motivated and disciplined I would imagine that you’ll have a hard time actually getting that money back into the account. Or, if you normally maximize your contributions each year anyway then you won’t even be able to pay it back.
Most experts will agree that taking out a withdrawal should truly be one of your last ditch efforts to keep you out of the financial dog house. A 401k loan ends up much better on paper almost every single time!
So, Should I use a 401k Loan for a Down Payment on a House?
Buying a home is such a big decision with so many far-reaching financial implications that it is always tough to decide exactly how to handle all the details. For our purposes, we’ll assume that the reason that you are considering a 401k loan for a down payment is that you simply don’t have the cash available for your new home.
In this situation you will at best be able to buy the house and pay for PMI (private mortgage insurance) for the first several years of the loan or at worst be denied the loan opportunity all together. Assuming that you are not able to come up with the down payment due to an inability to handle your money properly and that you aren’t trying to buy too much house, avoiding these two obstacles are two big reasons why you may want to consider the loan. Let’s also look at some typical scenarios and the math involved in deciding which method to choose.
Typical Home Buying Scenarios
Taking into consideration that PMI isn’t all that expensive at around .44% in that typical example, there is no way that it would be worth the losses to your your retirement accounts that could potentially add up to the double digits each year. Here’s that example without a 401k loan:
- Total home purchase price of $180,000
- PMI interest rate of .44%
- We’ll assume a 30-year mortgage with a 3.86% interest rate
- Total mortgage payments at an overall 4.3% interest rate of $890.77/month
- Total price paid: $320,677.20
Here’s the example with the 401k loan for a down payment:
- Total home purchase price of $180,000 – 20% down = $144,000
- No PMI interest
- 30-year mortgage with 4.06% interest
- 15-year $36,000 401k loan at 4.5% interest
- Mortgage payments of $692.47/month + 401k loan payments of $275.40/month = $967.87/month
- Total price paid: $298,861.20
On the surface it looks like using the 401k loan for a down payment could be a good option, but if we take a look at this 401k calculator we can see that the impact of this loan on our retirement savings would amount to $45,617 over the next 15 years.
If we add this cost in to the total price paid you will see the true total price paid rise to $344,478 which is $23,800.20 more than the example without the loan.
Now, if your mortgage interest rate was higher than 3.86% then you would come out ahead after a certain point because you would effectively be cutting in a lower rate for 20% of your mortgage. Quick math shows that this interest rate would need to be around 4.56% before the PMI to break even on costs. If you look at these numbers you could argue that someone with poor credit and therefore a higher interest rate on their mortgage loan would stand to come out ahead by taking out a 401k loan for a down payment in this type of scenario.
Let’s get real though, if you are financially responsible enough to have $88,000 in your 401k by the time you are ready to buy your first house, will you also have such poor command over your personal finances that your credit score would be in the gutter and guarantee that you get a high interest mortgage quote? Probably not. The average age of first-time home buyers in the US is 31 and the average 31-year old has about $12,500 saved up. Only a person with supreme discipline, high income, or both would be likely to have that sum in their account in the first place. If this were the case, finding some cash to put down on a new house is probably something that they’ve already worked on and accomplished leading up to the purchase.
So, the verdict is that although it’s entirely possible for taking out a 401k loan for a down payment to make sense, the fact is that it would be extremely unlikely to actually need to do it!
Have you or anyone you know ever taken out a 401k loan? Let me know your experiences or anything else you want to chime in with below in the comments!