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A down-payment dilemma
Should a 401(k) plan be tapped to buy a home? The strategy has pros and cons.
WALNUT CREEK, Calif. - Faced with a real estate market that has tightened lending standards when home values are dropping, more people are borrowing money from their 401(k) retirement plans to help swing a down payment to buy a home.
But before you think that borrowing from your employer-sponsored 401(k) retirement plan - or a 403(b) if you work for a school or nonprofit organization - is the ticket to buying a home, be aware that this strategy has pros and cons.
On the plus side, the loan principal and the interest are paid back to you, and the interest rate is lower (currently about 6.5 percent) than what a bank typically charges. Also, no credit check is required because you are lending yourself the money.
On the negative side, a loan could significantly reduce the retirement account's long-term growth and earning potential, especially if you stop making contributions while paying off the loan. (Not all plans allow you to make contributions while your loan is active.) There is also a tax hit if the loan is not repaid.
Whether you can actually borrow from a 401(k) is up to the plan sponsor, which is your employer. About half the plans sponsored by U.S. employers allow loans, according to industry statistics. Borrowing is typically capped at $50,000, or up to half the vested amount, and a minimum loan amount of $10,000 is required.
"Borrowing against your 401(k) is a very dumb idea," said Jim Titus, a vice president at the San Francisco headquarters of the financial-services firm the Charles Schwab Corp. "Number one is the opportunity costs of borrowing. You end up losing the [tax-deferred growth potential] when you take the money out of your 401(k), and the interest you pay back [on the loan] is unlikely to earn as much of a return as your 401(k) investment."
That said, there are reasons to consider borrowing from a retirement plan to take advantage of the steep drop in home prices that has followed the subprime-loan crisis that began last year.
"I'm seeing a lot of people touch upon their retirement accounts for down-payment money," said Dianne Crosby, a senior loan consultant in the Oakland, Calif., office of LaSalle Financial Services Inc., which is both a mortgage banker and a mortgage broker. "Right now, real estate is a depressed market; I think it's a great investment."
One question individuals have to ask is whether they would be better off taking out a retirement-fund loan now and using it for a down payment or waiting until they accumulate additional funds, said Gary Gardner, a certified financial planner and president of LifeWealth Advisors.
"There are some clear risks of using a 401(k) as a funding source for a down payment on a house. You have to assess those risks and weigh them against the particular economic opportunity you have to buy a home. Under normal circumstances, I think borrowing from a 401(k) to purchase a home is ill-advised. But because of what's going on in the real estate market, special and exceptional opportunities do arise," he said. "There are some tremendous values."
Keep in mind that lenders typically would treat the 401(k) loan as a form of debt. That could affect your qualifying for a home loan. The flip side is that using 401(k) money for a down payment could provide the equity to avoid paying mortgage insurance.
The loans are not subject to ordinary income taxes associated with withdrawals if the full amount is repaid. If the loan is not repaid, it is treated as a distribution subject to ordinary income taxes. A 10 percent early-withdrawal penalty also applies if the account holder is under the age of 591/2.
There are other things to be aware of.
An employee who loses a job has to repay most 401(k) loans within 60 to 90 days, Titus said. After that, the unpaid loan balance is treated as a distribution subject to income taxes and a possible early-withdrawal penalty.
That is why you must think about your job security before you take out a loan, Gardner and Titus said.
Continue to make regular contributions to your retirement plan if you can manage both. "You cannot stop saving toward retirement just because you bought a house," Gardner said.
By not making contributions while the loan is active, you could lose out on employer contributions, Titus said. "My advice if you cannot afford the home without the 401(k) loan: Don't buy the home."
Find out how a 401(k) loan could affect your retirement nest egg at http://go.philly.com/401(k). Choose the “Borrowing From a 401(k) Calculator” link.
Here is an example from the calculator for a 35-year-old who puts $200 a month into a 401(k) with a $40,000 balance. The investor takes out a $20,000 loan with an interest rate of 6.5 percent. Based on an average 8 percent return.
SOURCE: Standard & Poor’s
But before you think that borrowing from your employer-sponsored 401(k) retirement plan - or a 403(b) if you work for a school or nonprofit organization - is the ticket to buying a home, be aware that this strategy has pros and cons.
On the plus side, the loan principal and the interest are paid back to you, and the interest rate is lower (currently about 6.5 percent) than what a bank typically charges. Also, no credit check is required because you are lending yourself the money.
On the negative side, a loan could significantly reduce the retirement account's long-term growth and earning potential, especially if you stop making contributions while paying off the loan. (Not all plans allow you to make contributions while your loan is active.) There is also a tax hit if the loan is not repaid.
Whether you can actually borrow from a 401(k) is up to the plan sponsor, which is your employer. About half the plans sponsored by U.S. employers allow loans, according to industry statistics. Borrowing is typically capped at $50,000, or up to half the vested amount, and a minimum loan amount of $10,000 is required.
"Borrowing against your 401(k) is a very dumb idea," said Jim Titus, a vice president at the San Francisco headquarters of the financial-services firm the Charles Schwab Corp. "Number one is the opportunity costs of borrowing. You end up losing the [tax-deferred growth potential] when you take the money out of your 401(k), and the interest you pay back [on the loan] is unlikely to earn as much of a return as your 401(k) investment."
That said, there are reasons to consider borrowing from a retirement plan to take advantage of the steep drop in home prices that has followed the subprime-loan crisis that began last year.
"I'm seeing a lot of people touch upon their retirement accounts for down-payment money," said Dianne Crosby, a senior loan consultant in the Oakland, Calif., office of LaSalle Financial Services Inc., which is both a mortgage banker and a mortgage broker. "Right now, real estate is a depressed market; I think it's a great investment."
One question individuals have to ask is whether they would be better off taking out a retirement-fund loan now and using it for a down payment or waiting until they accumulate additional funds, said Gary Gardner, a certified financial planner and president of LifeWealth Advisors.
"There are some clear risks of using a 401(k) as a funding source for a down payment on a house. You have to assess those risks and weigh them against the particular economic opportunity you have to buy a home. Under normal circumstances, I think borrowing from a 401(k) to purchase a home is ill-advised. But because of what's going on in the real estate market, special and exceptional opportunities do arise," he said. "There are some tremendous values."
Keep in mind that lenders typically would treat the 401(k) loan as a form of debt. That could affect your qualifying for a home loan. The flip side is that using 401(k) money for a down payment could provide the equity to avoid paying mortgage insurance.
The loans are not subject to ordinary income taxes associated with withdrawals if the full amount is repaid. If the loan is not repaid, it is treated as a distribution subject to ordinary income taxes. A 10 percent early-withdrawal penalty also applies if the account holder is under the age of 591/2.
There are other things to be aware of.
An employee who loses a job has to repay most 401(k) loans within 60 to 90 days, Titus said. After that, the unpaid loan balance is treated as a distribution subject to income taxes and a possible early-withdrawal penalty.
That is why you must think about your job security before you take out a loan, Gardner and Titus said.
Continue to make regular contributions to your retirement plan if you can manage both. "You cannot stop saving toward retirement just because you bought a house," Gardner said.
By not making contributions while the loan is active, you could lose out on employer contributions, Titus said. "My advice if you cannot afford the home without the 401(k) loan: Don't buy the home."
Find out how a 401(k) loan could affect your retirement nest egg at http://go.philly.com/401(k). Choose the “Borrowing From a 401(k) Calculator” link.
Here is an example from the calculator for a 35-year-old who puts $200 a month into a 401(k) with a $40,000 balance. The investor takes out a $20,000 loan with an interest rate of 6.5 percent. Based on an average 8 percent return.
- Not making contributions of $200 a month while the loan is active: The investor will have saved $621,241 in the account by the time of retirement in 30 years. If the retirement plan were left intact without borrowing against it, the assets could grow to $737,488, a difference of $116,247.
- Making contributions of $200 a month while the loan is active: The investor will have saved $729,827 in the account by the time of retirement in 30 years. If the plan were left intact without borrowing against it, the assets could grow to $737,488, a difference of $7,661.
SOURCE: Standard & Poor’s
