Question: I want to use money from my 401k account to make a down payment on a home.
Can I use my 401k to buy a house? What are the pros and cons I should know about?”
There is a lot to think about when considering using your retirement savings as a down-payment on a home. Let’s be clear about one thing: we are talking about a primary resident. We are not talking about a second home or property for real estate investment purposes.
The short answer is yes, you can use your 401k to buy a house (for down-payment purposes only).
1st Things First
You are going to pay taxes (and maybe penalties) on the early withdrawal from a 401k or other tax deferred, defined contribution plan. 401k’s are by their very nature a “tax deferred investment program.” Thus, you are going to pay taxes on the back end when you withdraw.
Now, you need to know exactly how much you might pay in penalties. If you had a Roth IRA this would be a whole different conversation because you have already paid taxes. You can withdrawal at anytime without penalties. You may have to pay capital gains taxes on the income earned from the IRA (see a tax specialist on this).
Talk to your Plan Administrator about the fine print in your 401k contract to see how you can withdraw funds from your 401k account to cover the down payment.
The IRS allows you to withdrawal funds for hardships situations. Money to cover the down payment on a home that’s your primary residence may qualify as a hardship. You need to review the IRS rules for your particular situation. Look for the requirements of your down payment funding. Compare the cost options to the cost of using your 401k.
2nd Thing
What kind of mortgage loan are you looking for?
FHA Loans
If you use a FHA home loan, your down payment can be around 3.5% of the purchase price. Not familiar with FHA loans? Go to FHA: https://www.hud.gov/federal_housing_administration
These loans are backed by the federal government (through the Federal Housing Administration). You apply for the loan through a regular lender, such as Wells Fargo or Bank of America. But the loan gets insured by the FHA.
Your credit score may affect how much of a down payment you need for an FHA loan. Look at the current guidelines for borrowers with a credit score of above 620 to see what you qualify for. Remember: the lower your credit score the higher your payments will be.
Conventional Mortgage Loans
Conventional mortgage loans are not backed by the government. This makes them different from other forms of government-insured mortgages (FHA/VA). A conventional home loan will range from 5% – 20%, down payment depending on a host of factors. These mortgage loans may be backed by Fannie Mae or Freddie Mac. See your real estate agent and/or your mortgage broker for details (it depends on where you live).
Mortgage Insurance and Low LTV Loans
For single family mortgages of over an 80% loan-to-value of the purchase price, you will pay mortgage insurance on top of the loan. Ask your mortgage broker what this will be. It will add $75 – $150 to your monthly house note.
Strategies
If you use a 1st and 2nd down payment strategy you may avoid mortgage insurance. The bank loans you 80%, you get a second loan for 15%, you pay the remaining 5% in the form of a down payment (which lowers your down payment).
Don’t Forget Your Other Expenses
The mortgage business is a fee driven business. Don’t be surprised by fees related to your mortgage loan. Shop for the lowest closing costs.
Note: in some cased the lower the closing costs may increase the interest rate of the loan. The mortgage company has got to make money too. They will get their fees one way or another.
Don’t forget some lenders will require you have a certain amount of cash reserves in your the bank account. They want to know you have enough to cover several months of mortgage payments.
Rule of thumb: have six months reserve. Your 401k can be part of these reserves.
Look at all options for making a down payment. Taking an early withdrawal from your 401k may be more than it’s worth it. What strategy will costs you the least amount of headaches? Evaluate the tax implications for each method.
A word of caution: do not be in a rush. Investment in a home is one of the largest investments a person can make. Avoid the bidding war if you see you are in one. House hunting is like waiting for a bus, if you miss one, another one is coming.
I strongly recommend you get your 401k Plan Documents, sit with a Financial Planner or/and experienced mortgage broker and a CPA to walk you though this maze of options.
As always, use the School of Higher Learning for your research and information: The Internet!
