With mortgage rates hovering around historic lows, now is a
great time for many people to become first-time homebuyers.
But, if you don't have healthy savings built up in your bank
account, you may be thinking about tapping your 401(k) balance to make a down
payment. You are, technically, allowed to do that, but experts generally agree
that drawing from your retirement savings is not the best way to achieve
homeownership.
If you're thinking of going down that path, here are some
considerations, and a few alternatives.
What's involved in dipping into your 401(k) to buy a house
Federal rules allow you to borrow up to $50,000 or half the
value of the account, whichever is less, to use the money for a home purchase.
You won't owe a 10 percent penalty on the withdrawal if you're under 59.5 years
of age. You can repay the money without having to pay taxes.
However, if you lose your job the money will have to be
repaid by your next federal tax return or it will be considered a withdrawal
and you'll be taxed on the sum at your full rate, plus that penalty. In
addition, many plans won't let you make new contributions until you repay the
loan.
So this loan can be costly in terms of what you won't be
saving, as well as possibly forgoing a company match on your contributions.
Why borrowing from a 401(k) is a bad idea
"Leave retirement money for retirement," said Greg
McBride, Bankrate's chief financial analyst. "There are plenty of other
low down payment options, particularly for first-time homebuyers."
Drawing funds from your 401(k) account is essentially a
permanent setback to your retirement finances. "The money you take out,
even if you later put it back in, that's just money you're replacing," he
said. "You're always going to be behind where you could have been."
Cathy Pareto, president of Cathy Pareto and Associates, a
Coral Gables, Florida-based financial advising firm, agrees that using 401(k)
money toward purchasing a house is ""probably not the best use of
those dollars." She also underscored the logic that that money, once
spent, can never fully be recouped.
'The time value of money is critical to the growth of a
portfolio," she said. Taking money out of a retirement account prevents it
from compounding interest. The 401(k) allows employed people to set aside part
of their salary tax-free and let that money grow tax-free until it's withdrawn
at retirement. As of June 2020, some $28 trillion is salted away in these
accounts.
Plus, Pareto added, some 401(k) plans won't let you borrow
money anyway.
If you have to rely on your 401(k) money, save more before
becoming a homeowner
"The ability to save consistently is an important
determinant of success as a homeowner," McBride said. "If you haven't
figured out how to save money before you buy the house, you are not going to
figure out afterwards."
Owning your own home requires financial discipline beyond
just saving enough for a down payment.
Unexpected repairs can pop up at any time when you are your
own landlord, and you'll also have to pay for property taxes and other
expenses, including possible HOA fees on top of your monthly mortgage payments.
"If you're having to stretch to buy the house, you have
to do a cost-benefit analysis." Pareto said. "If you're going to have
to commit financial suicide for that, I'm not sure that's the best
decision."
Alternatives to drawing from your 401(k) to buy a house
“If you're stretching to buy a house and you don't have the
capital outside of a retirement plan, it begs the question: can you afford to
buy the house?" Pareto said. It's best to build up your other savings
accounts before you buy a house. "Maybe minimize what they're contributing
to the 401(k) until they can sure up capital."
McBride agrees. "If you don't have a demonstrated track
record of saving money, that's something you want to establish before you take
the plunge into homeownership," he said. "Buying before you're
financially ready can really limit your financial capabilities. Everything
about owning a home costs money."
But, he said, even if you have small balances in your
savings accounts, you may still be eligible to buy a home with a down payment
smaller than the standard 20 percent.
Especially for first time homebuyers and other qualified
applicants, there are a number of federally-subsidized programs that can help
you realize that goal, including FHA and VA loans.
Bottom line
Relying on your 401(k) to finance a home purchase is almost
never the right decision for most homebuyers. Instead, you're better off
focusing on growing the rest of your portfolio, and earmarking a regular
savings account for a downpayment in the future.
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