Things to know before taking a 401(k) loan for a home down payment

Financial Planners

Barbara Marquand NerdWallet

If you’re struggling to save for a home down payment, a 401(k) loan may seem like a quick and easy solution.

According to the Federal Reserve’s Consumer Finance Survey, the median American with a retirement account that includes a 401(k) was $65,000 based on the latest 2019 data. The median value for trading accounts, including savings accounts, checking accounts, and money market accounts, was $5,300.

Many employer plans allow 401(k) loans, and the benefits are compelling. You are basically borrowing from yourself and paying interest to yourself. Loans aren’t usually counted as liabilities when lenders calculate your debt-to-income ratio.

But borrowing from retirement savings has its downsides, and some financial planners advise avoiding it.

said JP Geisbauer, Certified Financial Planner and Principal at Centrepoint Financial Management in Irvine, California.

Still, Nathaniel Moore, a certified financial planner and president of Agape Planning Partners in Fresno, California, says he understands why someone would be tempted. “If that means moving from paying high rent to moving into a place you own, I understand that,” he says.

If you are thinking about it, please refer to this.

borrowing rules

Most 401(k) plans allow loans, but federal law doesn’t require them. Log on to a website that tracks your 401(k) and look up your loan information, or contact your employer’s human resources department or plan administrator.

Some loan terms vary by employer’s plan, but all plans must comply with federal regulations.

  • The maximum loan limit is $50,000 or 50% of the confirmed account balance, whichever is less. Or up to $10,000 if 50% of the firmed balance is less than $10,000. If your balance is $200,000, you can borrow up to $50,000. If your vested balance is $70,000, your maximum loan amount is $35,000.
  • You have a certain period of time to repay the loan and interest. Otherwise, it will be considered distribution or withdrawal. Distributions are subject to income tax, plus an additional 10% tax if you are under 59½. The plan sets the interest rate. Usually 1% or 2% higher than the prime rate.
  • Generally, a 401(k) loan must be repaid within five years, but plans can give you more time to pay off your primary home loan. Payments must be made at least quarterly over the life of the loan.
  • If you get fired or quit your job, the plan is to pay off any outstanding loan balances in full. If unable to pay, the unpaid amount will be subject to tax and if less than 59 1/2 he will be subject to a 10% tax penalty. By the next annual federal tax filing deadline, you can roll forward any unpaid balance to your IRA or another eligible plan to avoid tax consequences. According to a 2022 Vanguard report, about four-tenths of Vanguard plans allowed participants to continue paying off their loans after quitting their jobs in 2021.

Risks of Using a 401(k) Loan

Even if you believe a 401(k) loan is for you, it’s important to understand the risks first.

One is the potential tax burden if you miss your quarterly loan payments or quit your job and fail to pay off your outstanding balance on time.

It can also delay retirement savings. In addition to losing the potential investment return on the money you borrowed, repaying the loan may impair your ability to contribute to your 401(k). In fact, Annamarie Mock, a certified financial planner at Highland Financial Advisors in Wayne, New Jersey, says some plans don’t allow employees to make regular contributions until the loan is paid off. increase. Suspension of contributions is especially costly if you miss matching contributions from your employer.

But there is another, less obvious risk. What Moore finds particularly troubling is that once you get a loan, it’s easy to get it again. “We are reprogramming our mindset to give us access to 401(k)s that are protected and designed to provide income in the future,” he says.

Loan costs, repayments and alternatives

If you’re thinking of borrowing from a 401(k), do the following:

Check your plan’s rules for 401(k) loans

Get details about interest rates, fees, payments, and loan repayment terms.

Calculate if you can afford to pay your loan

Aggregate loan payments together with other debts.

“That 401(k) loan is deducted from your paycheck right from the start, so make sure your new home costs, living expenses, and savings don’t put you in the red every month,” says Mock. Say. If loan payments are out of reach, “the only other place I can support that lifestyle is through very high credit card debt,” she says.

Learn what happens when you quit your job

If your plan requires you to pay the outstanding balance in a short period of time, as most plans do, strategize how to pay back that amount to avoid tax implications.

consider alternatives

Finally, check out other options to help you buy a home, such as low down payment mortgages and the state’s First Home Buyer Program, advises Mock. Perhaps one of them could eliminate the need for 401(k) loans.

Some traditional loans have a down payment as low as 3%. The down payment for FHA loans guaranteed by the Federal Housing Administration is 3.5%. Also, if you are a military or veteran, you may qualify for a no down payment VA loan backed by the U.S. Department of Veterans Affairs. USDA loans for rural homebuyers also require no down payment.

The state’s First Home Buyer Program offers assistance with down payment and closing costs. These programs also offer low down payment loans from approved lenders.

Still need a 401(k) loan?

Moore offers the following tips:

  • Borrow only what you need. It may be less than the maximum amount you can borrow.
  • Please repay aggressively. Just because you have a certain number of years to pay off a loan doesn’t mean you have to use it all that time. “Try to pay it off as soon as possible.”
  • Watch out for reborrowing trends. “You don’t want to get into the habit of looking at your 401(k) like a piggy bank.”

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Barbara Marquand writes for NerdWallet. Email: twitter: @barbaramarquand.

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