One of the largest factors in your ability to buy a home is the down payment. Most mortgage programs require some type of money down on the home, even if it is gift money. The only exceptions to this rule are VA and USDA loans, both of which require you to have special circumstances to qualify.
Luckily, if you have a 401(K), you may be able to use those funds to put down on your home purchase.
How to Borrow From Your 401(K)
There is a difference between borrowing funds and withdrawing funds from your 401(K). You want to do the former. If you withdraw the funds, it results in early withdrawal penalties and tax consequences, but borrowing works just like a loan.
You’ll have to talk to your plan administrator to determine what options you have. Each plan has different rules. Usually, you can borrow the lesser of up to half of the account balance or $50,000. Borrowing the funds does not result in an early withdrawal penalty or tax consequences. It does, however, require you to pay interest, just as you would on any other loan.
The Terms of the Loan
Again, every plan is different, but in general, you can expect the following:
- You’ll usually have a maximum of 5 years to pay the money back with interest. Make sure you can afford the payments based on the amount you borrow.
- The interest rate is often 2 points more than the current prime rate. Using a loan calculator, you can determine your payments based on the current prime rate.
- If you leave your company, the loan may become due and payable within a matter of a few months. If you can’t pay it back, you’ll have to take an early withdrawal, which means penalties and tax consequences.
How a 401(K) Loan Affects Your Mortgage Application
When you apply for a mortgage, the lender must calculate your debt ratio. In that debt ratio are all of your debts reporting on the credit report. The most common debts include:
- Credit card (minimum payments)
- Car loans
- Student loans
- Personal loans
- Mortgage payments
The lender totals up the payments reporting on the credit report and compares it to your gross monthly income. However, if you take a 401(K) loan to make your down payment, the lender must also include that payment in your debt ratio.
This means the 401(K) loan could hurt your chances of loan approval. That doesn’t mean it always will; it depends on where your debt ratio is compared to the maximum allowed ratios for the program. For example, if you apply for a conventional loan, your total debt ratio cannot exceed 36%. If you are close to that maximum before the loan from your retirement fund, you might go over it with the loan.
Whether or not it kills your loan approval is up to the lender. Oftentimes, having compensating factors can help offset the higher debt ratio. A high credit score, stable, income, or stable employment can help your case with the lender.
Paying the Interest
While it might seem disheartening to pay interest on a 401(K) loan since you are essentially borrowing your own money, there’s good news. The interest you pay goes directly into your own account. It’s not interest you pay to a bank or any other lender. It’s a way to help keep your retirement account balance growing despite the fact that you took the money out of the investment account.
Should You Use a 401(K) Loan?
Now, the bigger question is whether you should use a 401(K) loan for a home down payment or not. Unfortunately, there’s no cut and dry answer. It depends on your situation.
Before you do, consider all of your options:
- Are you eligible for a USDA or VA loan? You won’t need a down payment if you use either of these loan programs.
- Do you have another source of funds, including a gift from a relative or employer?
- Is your debt ratio in line so that the 401(K) loan won’t ruin your approval?
- Does it benefit you to put the money down or do you have enough of your own money to meet the minimum requirement?
Talking these options through with your lender can help you decide what is right. Sometimes, not putting the money down and leaving it in your 401(K) is the better answer. Yes, you may have a higher monthly payment, but it’s likely less than it would cost you to pay back your retirement funds. Plus it gives your retirement funds a better chance to grow beyond what you would pay in interest.