Can I use my 401(k) for a down payment on a home purchase?

One of the biggest obstacles when buying a home — especially for first-time homebuyers — is coming up with the down payment. That’s why some people use their 401(k) for a down payment instead of saving up the cash.

If you’re having trouble gathering money for a down payment, pulling from your retirement fund is an option. But drawing from your 401(k) comes with a few drawbacks.

Here’s what you should know before using a 401(k) to buy a house.

Using your 401(k) to buy a new home: allowed but not recommended

While using a 401(k) for a mortgage down payment is possible, it’s not necessarily the best option.

A 401(k) is an employer-sponsored plan intended for retirement purposes. Each year, you can contribute a certain amount to your account. Some employers will even match some or all of your contributions, making it easier to prepare for retirement.

The amount you contribute to the plan is pre-tax, meaning your money is deposited into your 401(k) account before it gets taxed. This deducts your contributions from your taxable income, so you could end up paying less income tax each year that you contribute. Once you turn 65 years old (or 59 1/2, in some cases), you can withdraw from your plan without penalty. You could, however, be taxed on the amount.

Although you can technically withdraw money from your 401(k) for any reason, you might face a 10% early withdrawal penalty. Taking money out of your account also cuts into your total retirement savings. So, while it might seem like a good idea to use the money for a down payment, it’s wise to consider the long-term costs first.

How to use a 401(k) to buy a house

If you want to use your 401(k) to buy a house, you have two options:

• 401(k) early withdrawal: If you want to tap into your 401(k) for a down payment, you can make an early withdrawal whenever you choose and for any reason. However, you may be subject to a 10% early withdrawal penalty if you use money from your 401(k) before your plan’s retirement age. Some exceptions exist, such as for cases of total and permanent disability. The advantage of early withdrawal is that you will not need to repay the money you withdraw.
• 401(k) loan: With this option, you’ll borrow from your retirement plan and repay the loan  back to your account via payroll deductions. Similar to a standard installment loan, you’ll pay interest on the funds you borrow — but this interest will be applied to your 401(k) savings. 401(k) loans typically have to be repaid within five years, but your repayment term can be longer if you use the loan to buy a home. So, it’s best to only take out the exact money you need — and that you can reasonably pay back on time.

While a 401(k) withdrawal permanently removes funds from your savings, a 401(k) loan allows you to borrow and repay money to yourself with interest over time. Additionally, because you can avoid the 10% early withdrawal penalty by taking out a 401(k) loan, this plan is typically the better option for minimizing costs. 

Downsides to 401(k) loans for home buying

Using a 401(k) loan to buy a home or pay off a mortgage early could be helpful, but it also comes with some drawbacks.

• The loan amount may be limited. You can borrow up to $50,000 or 50% of your 401(k) account’s current balance (whichever is less). For example, if your 401(k) balance is $30,000, the maximum amount you can borrow is $15,000. This might not be enough for a down payment.
• Not every plan is eligible. Some 401(k) retirement plans do not give you the option of taking out a loan. In that case, you’ll need to explore other means, such as down payment assistance programs.
• Your 401(k) must be with your current employer. You can only take out a loan if your plan is currently active. If you have an old plan but never rolled it over into a new one, you won’t be able to get a loan.
• It could come with additional fees. While a 401(k) loan might be cheaper than an early withdrawal, it can still come with fees like maintenance or origination fees.
• You could lose potential interest gains. The less money you have in your retirement account, the less interest it can gain. This could cut into your retirement savings. However, you may still be able to contribute to the account while paying back the loan. Repayments will not count as part of your annual contributions.

Using a 401(k) withdrawal to buy a house

While withdrawing from your 401(k) for a down payment may be tempting, there are several reasons why it’s not recommended.

• You’ll most likely be hit with the 10% early withdrawal penalty. Exceptions do exist, but they’re limited. For example, you’ll have to meet age or hardship requirements to avoid the 10% fee.
• You’ll miss out on long-term growth. In addition to taxes and other penalties, withdrawing from your 401(k) also limits your account’s growth from compound interest.
• A 401(k) loan may be cheaper. As long as you repay the loan (plus interest), you can avoid additional taxes and penalties.

Can I use my 401(k) to buy a house without penalty?

Typically, you’ll have to pay a 10% early withdrawal penalty for taking money from your 401(k) account. However, you may be able to avoid this penalty if you:

• Take out a 401(k) loan to buy a house.
• Are at least 59 1/2 years of age (or 55 if you’re no longer employed).
• Qualify for a hardship distribution due to an immediate financial need.
• Are using a Roth 401(k) — these accounts are penalty-free, but you may have to pay taxes on any earnings.
• Experience total and permanent disability.

Using your 401(k) for a down payment as a first-time homebuyer

If you’re a first-time homebuyer, coming up with the down payment for a house can feel daunting. Depending on the cost of the home and the loan type, you could be looking at spending tens of thousands of dollars — if not more.

For example, you’ll typically need a minimum down payment of 3.5% for an FHA loan. This is roughly $11,429 on a $400,000 mortgage.

A conventional mortgage lender might require a higher down payment, especially if you have limited credit. You’ll also need to put at least 20% down if you want to avoid taking out private mortgage insurance (PMI).

But using your 401(k) for a down payment can be more costly than you might realize, especially when you consider the long-term effects. The hefty withdrawal penalty alone can cut into how much you actually receive.

Even if you take out a 401(k) loan, you could still face potential financial setbacks. For instance, if you lose your current job and fail to repay the loan in the predetermined amount of time, you could end up with penalties or have to pay taxes on the remaining amount.

Additionally, having an unpaid loan balance will leave you with less money saved for retirement.

Alternatives to using your 401(k) to buy a house

If you need help buying a house, you may qualify for alternative 401(k) loan options like down payment and closing cost assistance programs. Or, if you have another retirement account, like a Roth IRA, you may be able to withdraw from that instead.

1. Down payment and closing cost assistance

Many states offer down payment and closing cost assistance programs to first-time homebuyers, active military members, and teachers with low- or moderate-income. Options include forgivable cash grants, zero-interest loans, and full-interest loans.

It’s important to check the details of these programs since many come with additional requirements. For example, to qualify for New York’s HomeFirst Down Payment Assistance Program, you’ll need to make less than 80% of the area median income.

For assistance programs intended for first-time homebuyers, you’ll have to meet some general criteria to qualify:

• Haven’t owned a home in the last 3 years
• Have a 620 minimum credit score
• Can provide at least a 3% down payment
• Have consistent income and employment
• Have a debt-to-income (DTI) ratio under 43%
• Have no bankruptcies or defaults on your credit history

2. Consider using Roth IRA withdrawals instead

A Roth IRA is a retirement plan that works differently from a traditional 401(k). Roth IRAs are Individual Retirement Accounts that you make contributions to with after-tax dollars. Because the contributions you make have already been taxed, this allows your savings and any earnings to grow tax-free. 

With a Roth IRA, you can make qualifying withdrawals up to $10,000 without additional penalty or taxes. To qualify, you’ll need to be a first-time homebuyer and have an account that’s at least five years old. However, if you don’t use the funds within 120 days of withdrawal, you may owe taxes or other penalties.

3. Consider a non-conventional home loan

Some home loans, such as VA loans, don’t require a down payment or private mortgage insurance. You’ll need to be a qualifying service member or veteran to get a VA loan, though.

To be eligible for a VA loan, you’ll typically have to meet the following criteria:

• Meet active-duty service requirements: Active-duty service members must have served 90 consecutive days, while veteran minimum service requirements depend on when you served.
• Have a valid COE: You must have a valid Certificate of Eligibility from the government. You can get a COE — through your lender, on eBenefits, or through the VA’s download form 26-1880 —  if you didn’t receive a dishonorable discharge and meet minimum service requirements.
• Meet credit and income requirements: You’ll need to meet your lender’s specific minimum income and credit requirements.
• Spousal eligibility: You’re the surviving spouse of a service member who’s missing in action, a prisoner of war, or who died in the line of duty or from a service-related injury.

Certain lenders will also accept a lower down payment if you have good credit and income. Check around to see what your best, qualifying options are.

Should I use 401(k) funds to avoid PMI?

Private mortgage insurance, or PMI, is a type of homeowners insurance. Lenders typically require it if you get a conventional mortgage without putting at least 20% down. It’s an additional cost that lenders usually tack on to your monthly payment to protect themselves in case you default on the home loan. Once you’ve built up at least 20% equity in your home, you can typically cancel the PMI and lower your monthly payments.

If you want to buy a home, you may be considering using your 401(k) to help with the down payment and avoid PMI. Before you do, consider the pros and cons of doing so.

401(k) loans can leave you behind financially, while PMI won’t

If you decide to use a 401(k) loan for your down payment, you might qualify for a better interest rate with a mortgage lender while also avoiding PMI. However, you’ll still be responsible for making monthly payments on the loan — plus interest. Depending on what you would have spent on PMI, this might not save you any money.

Additionally, you typically only have about five years to repay a 401(k) loan. This could mean high monthly payments, especially if you borrow a larger amount.

You can drop or refinance PMI

You can remove private mortgage insurance in a few different ways:

• Ask the lender to drop it. You can typically do this once you’ve earned at least 20% equity in your home.
• Wait for your lender to remove it.  This usually happens once your home loan reaches its midway point, or your mortgage balance is 78% of the original purchase price.
• Refinance your mortgage. This can lower your monthly payment at the cost of resetting your home loan.
• Get your home appraised. This can help you determine if your home has gained the 20% equity required to drop PMI.

Does this plan really make sense in the long term?

Ask yourself whether using your 401(k) or paying the PMI makes the most financial sense in the long run. Calculate how much your monthly mortgage payment will be with the PMI versus how much you’ll be paying for early withdrawal from your retirement plan. You can use a mortgage calculator for the first, and an early withdrawal calculator for the latter to estimate the costs.

Also, consider the risks of using your retirement savings to cover your down payment. The money you take out from your 401(k) account will not grow as you might have originally planned. This could leave you with less money during your retirement years.

Find out if you qualify for a mortgage loan without 401(k) funds

Buying a home is a major financial decision, especially when you consider factors like down payments and closing costs. If you have a 401(k), it can seem like a good idea to use the funds to help with the cost of a home purchase. But there are other ways to qualify for a mortgage — without needing to dip into your retirement funds.

Many lenders consider other factors aside from your down payment when determining your eligibility for a loan. This includes things like your credit score, income, total debt amount, and other assets, like your savings.

A good first step is to speak with a mortgage lender to see if you’ll be able to qualify for a mortgage and determine what aspects of your financial profile you can improve to increase your chances of getting approved for a loan.

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