What You Should Know About Using A 401 Loan For A Home Purchase
Not all 401 plans allow loans, but many employers, especially larger companies, offer a loan feature. Your plan paperwork will indicate if it provides 401 loans, or you can check with your plans administrator.
Before taking a loan from your 401, make sure you have a plan. Only withdraw what you need loans are limited to the lesser of $50,000 or 50% of your vested account balance), and make sure you know how youll repay the loan. The typical 401 loan term is five years, during which borrowers will need to make similarly equal payments at least quarterly. Although, in the case of a 401 loan for a home purchase, borrowers have longer to pay the loan back up to 25 years with some plans.
Another factor to consider is that if you leave your job or are terminated, your employer may require you to pay the outstanding balance. If youre unable to pay it within the specified time typically 90 days the money will be counted as income. Youll pay income tax at your current rate as well as the 10% early withdrawal penalty if youre under 59 ½.
Other Down Payment Funding Options
Taking money from your 401 either in loan or withdrawal form is not the only way to come up with money that you can use for a down payment on a house. Here are some other options that are available:
- FHA Loans
If you’re a first-time homebuyer, you can get an FHA loan to finance your home purchase. With an FHA loan, you will not have to put down 1020%. Instead, you can put a minimum of 3.5% down as long as your credit score is above 580.
- Gift From Friends or Family
If you have a generous friend or family member who is willing to help you out with a down payment, then this is a good option. Most lenders will allow gifts to be used for a down payment. However, the amount of gift money that can be used for the down payment may vary depending on the type of loan and the lender. Be sure to ask your lender what their policies are before you try to use a gift as a down payment.
One party that you are not allowed to get a gift from for a down payment is the seller. As Sullivan at HUD explains, “We have long prohibited that the sources of payment be the seller. It is critically important that there be separation between buyer and seller in the transaction. There was a time, for a while, when the FHA would insure mortgages where the buyer of the home was contributing a down payment that was financed by the seller. We found those loans to be incredibly risky and defaulted at a much greater rate. And so, we prohibited that practice.”
- IRA Withdrawals
- Assistance Programs
- Sell Assets
What Is An Ira
An IRA is a type of account set up at a bank, brokerage firm, mutual fund company, insurance company or other types of financial institution. Regardless of where the account is held, the purpose is the same: it is a place to hold assets to be used during retirement. IRAs can be used to invest in many types of assets . Some IRAs can be self-directed, allowing you to choose how to invest, ranging from investing in CDs, government bonds, mutual funds, stocks, even investment property .
There are many kinds of IRAs, but the two most common are Traditional IRAs and Roth IRAs. They differ based on the tax rules that regulate each type of IRA account, and specifically, how and when the account holder gets a tax break.
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What Is A 401 Retirement Plan
401 retirement plans are investment accounts with automatic tax breaks.
Congress made 401 plans possible when it passed the Revenue Act of 1978. The bi-partisan bill modified the Internal Revenue Code Section 401 and eliminated taxes on deferred employee compensation.
By 1981, the IRS changed its rules so employers could fund retirement plans, and today, more than half of U.S. workers participate in an employee-sponsored 401 retirement plan.
The IRS supports two 401 plan types:
- Traditional 401: Contribute tax-free and pay taxes upon withdrawal.
- Roth 401: Contribute taxed dollars and pay no taxes upon withdrawal.
Employers typically provide a traditional 401 or a Roth 401 plan as part of an employee benefits package.
Pros And Cons Of Using A 401 Loan
How do you know if the strategy will work for you? You have to weigh the alternatives:
Pros:
- If the numbers work, a 401 down payment loan might have advantages. Compare what a monthly mortgage would cost with and without mortgage insurance, then compute how much you would have to pay back to your 401 each month if you were to borrow from it. Remember that mortgage insurance isnt tax deductible, so anything you spend on it is a loss. A 401 loan is money youre borrowing from yourself, so you dont lose anything.
- A home is an investment that typically appreciates over time, and the equity you build in it is an asset. When you eventually sell it, you usually can pocket a lot of its appreciated value tax free. If its an investment that makes sense to you, arranging the best finance package should be part of the equation.
- Mortgage insurance isnt cheap. Its a good idea to avoid paying it, but you need to consider your ability to repay the 401 before using it as a solution.
Cons:
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Should You Use Your 401 To Buy A House
In general, home buyers should not use their 401 to help buy a home except as a last resort when:
Even then, home buyers should investigate every available option before taking money from their 401 to fund the purchase of a home.
Taking money from your 401 is a high-cost transaction:
- A tax is assessed on early withdrawal
- A penalty fee may be charged on cash withdrawn
- The tax advantages of investing are lost or reset permanently
When retirement account balances shrink, they provide less money for the future, which may extend a persons working life by up to a decade.
Using a 401 to buy a home is rarely a good idea. Instead, buyers should look to low- and no down payment mortgages, and seek additional downpayment assistance for first-time home buyers, if necessary.
The cost of using a 401 to buy a home is too large.
How Much House Can You Afford
Generally speaking for conventional mortgage income qualifications, your monthly mortgage payment including principal, interest, property taxes and homeowners insurance shouldnt exceed 28% of your gross monthly income. Governmental loan programs may have higher percentage income qualifications. Youll also need to factor in any remodeling, landscaping or other home improvement projects you want to do both now and later to help determine if a particular house will fit into your longer-term budget.
Dont forget to calculate your other home expenses. Theres the down payment, mortgage payments, insurance, utilities, maintenance and taxes to name a few. Remember to think about how your income might grow over the years. Run the numbers on several different home price points, and calculate your down and mortgage payments to get a feel for what your ideal price range is.
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Can You Use Your 401k For A Down Payment
You should be able to use money from your 401k to cover the cost of your down payment when buying a home. You could also use these funds to pay closing costs, but it may not be the best long-term decision.
There are limits to the amount you can take from your retirement plan. So while you can use it to contribute to your down payment, you wont be able to buy a home outright with the money.
There are two ways to use your 401k to buy your home. You can either withdraw money from the plan or take a loan from it. Lets review the advantages and disadvantages of each option.
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Purchasing real estate in a solo 401k is not that difficult as long as you follow the rules. As trustee of a solo 401k plan, you can invest in a number of real estate investments. These investments can include Apartment Buildings, Mobile Homes, Homes, Raw Land, Commercial Buildings, and more.
With a Solo 401K Real Estate, also called Self-Directed Solo 401K, various real-estate investments just mentioned can be held inside the 401K, much like mutual funds are in a work-sponsored 401K. Most of these rules are similarly applied to cash balance plans.
In addition, with what is known as Tenancy-in-Common, as the business owner you can partner with your Solo 401K to invest in real estate. As you can imagine, there are rules to follow. One is that no debt can be used. Another rule is you cannot purchase a property that was previously owned by you or certain family members.
Loans are also permitted by a third-party, not the 401K owner or certain family members, in order to invest in real estate. By definition, this is called a non-recourse or debt-financing .
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You Can But It’s Usually Not A Good Idea
Marcus Reeves is a writer, publisher, and journalist whose business and pop culture writings have appeared in several prominent publications, including The New York Times, The Washington Post, Rolling Stone, and the San Francisco Chronicle. He is an adjunct instructor of writing at New York University.
If you’re short on cash for a down payment, and you happen to have a retirement plan at work, you might be wondering if you can use a 401 to buy a house. The short answer is yesyou can withdraw from your 401 for a house. However, a 401 withdrawal for a home purchase is generally not the best move, given there is an opportunity cost in doing so. Here’s a look at tapping your 401 for homeownership, along with some better alternatives. .
How To Take A 401 Loan For A Home Purchase
An alternative to 401 withdrawals for a home purchase is to borrow against your 401 balance. Loans differ from distributions because you have to pay the money back to your account with interest. As a result, 401 loans are not subject to income tax or the early withdrawal penalty tax as long as you repay the loan as agreed.
While taking a loan from your 401 can be a less expensive option than using a 401 withdrawal for a house down payment, it has drawbacks. Like using 401 withdrawals for a home purchase, youll be eating into your retirement funds and removing the money from future earnings potential. Also, you may incur loan fees, and youll be paying back the loan at market interest rates similar to what youd pay on a personal loan and higher than what youd pay on a mortgage-related product. And since you typically repay 401 loans through payroll deductions, your net income will be lower while youre repaying the loan.
Additionally, youll be paying the 401 loan back with after-tax dollars, and then the money will get taxed again when you withdraw funds during your retirement years. This double tax is counterproductive to one of the primary benefits of contributing to a 401 plan.
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Should I Tap My 401 To Buy A Home
First-time home buyers are often young and financially stressed, struggling with student loan debts, car payments and the costs of raising young children. Even for couples with two incomes, the task of saving for a down payment can seem impossible.
But wait, why not borrow from a 401-retirement account to cover the down payment? Its tempting for those who have large enough 401 accounts and employers that allow borrowing from it. Tempting, yes, but wise? It depends.
Federal tax rules allow you to borrow half the vested funds in your 401, up to $50,000, for a down payment, but only if your company plan permits it. The loan to yourself doesnt require you to pay tax on the withdrawal, nor are there any penalties. But it is a loan, and youre required to pay it back. Fail to return the money to your account and youll owe taxes and a 10% penalty.
Borrowing from a 401 beats the alternative, taking a hardship withdrawal from the account.
Borrowing from a 401 beats the alternative, taking a hardship withdrawal from the account. Though some company plans allow hardship withdrawals, youll have to pay taxes on the money you take out as well as a 10% penalty. Obviously, this is a costly way to access your money.
Both borrowing and early withdrawals have a common disadvantage they take money that should be growing to cover your eventual retirement and use it for another purpose.
You Can Also Borrow From Your 401 But There Are Downsides
According to Quicken Loans, you can often borrow from your 401generally up to 50 percent of your vested account balance or $50,000, whichever amount is lessalthough the company advises checking with your employer or HR department to determine whether your 401 plan even allows loans.
The company also notes that youll have an allotted time for repaying the loan, which is usually within five years. Youll pay interest on the loan, which is often 2 points over the prime rate. The loan might impact your debt-to-income ratio and make it harder to get a mortgage.
However, there are upsides. Quicken Loans said, Besides allowing you to make a purchase you might otherwise not be able to make, borrowing from your 401 is basically borrowing from yourself, rather than another lender. That means that you might not be losing as much money on interest payments as you would if you got the funds via another means.
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Benefits Of Buying A Home In Retirement
Buying a home in retirement can be a smart move for a number of reasons.
1) Mortgage payments can stabilize your housing costs
If you are on a fixed income, or you anticipate living on a fixed income after youâve fully retired, a fixed-rate mortgage gives you control over your budget.
Although property taxes and homeowners insurance costs can fluctuate, your principal and interest payments remain the same. That can bring more peace of mind, and make financial planning much less challenging, than trying to anticipate whether your rent will increase each year.
2) Interest rates are at historic lows
If youâre thinking about getting a mortgage, itâs to your advantage to apply for one when rates are low. A low interest rate also helps keep your housing payments manageable.
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3) There are tax advantages*
You can deduct mortgage interest and property taxes on your income tax return each year, reducing your tax obligations. Plus, many states give senior citizens a break on their property taxes. So you may owe less than younger homeowners, and you can deduct property taxes on your yearly return.
4) Your overall stability increases
5) Modify your home to age in place
Tap Your Ira Or Roth Ira Instead
Best for: First-time homebuyers who need $10,000 or less for a down payment
You normally need to be 59½ to take penalty-free distributions from your IRA, but the IRS allows an exception for qualified first-time homebuyer distributions.
As long as you put any early distributions of up to $10,000 toward buying or building your first home, you wont have to pay the additional 10% tax on it.
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Is Buying A House With Your 401 A Good Idea
Coming up with the money to afford a down payment on a house can be challenging for some borrowers. While using cash from your 401 to cover the upfront costs of homebuying is technically possible, its not always the best option available. Before starting the withdrawal process, you might want to investigate other loan options with more flexible down payment alternatives. . Some mortgage loans allow you to put as little as 3% of the homes purchase price down.
If you know youre ready to start the homebuying process, see what rates you qualify for and get pre-approved to understand your options. At Better Mortgage, you can get pre-approved in as little as 3 minutes.
Evaluating The Value Of Financial Assets
You can still qualify for a mortgage at retirement if you have enough investments that can act as your source of income. The asset depletion technique aims at evaluating the current value of your assets.
After deducting the closing costs and down payments, the lender divides 70% of the remaining amount by 360 months to find your monthly income.
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