It's no secret that home prices are growing. The average sale price for a new home in the U.S. was $379,500 in June, according to the U.S. Census Bureau, compared to $271,800 in the same month in 2012.
The large price tag on a home makes it difficult and, sometimes, seemingly impossible to buy real estate. The down payment, whether its 3 percent, 20 percent or anywhere in between, is a major obstacle for many buyers, and a common reason people don’t buy real estate. But this is because a lot of potential buyers don’t realize the extent of the options available to them.
One of these options is the ability to use your retirement plan – 401(k) or IRA – to help toward the down payment on a home without penalties. The IRS has guidelines for taking out a loan from your retirement plan, including a limit of 50 percent of your account balance, or $50,000, whichever is less – which could be just enough to afford a down payment, depending on the price of the home and your mortgage program. Always consult with an accountant or financial planner to ensure you are doing it correctly.
Retirement plans are all different, and each one is going to have its own specific set of rules and guidelines for taking out a loan. It’s not as difficult as it may seem and you will find it’s pretty general across the board.
When does it make sense to take a loan from your retirement savings?
The most common reasons someone would use a loan from their 401(k) or IRA is to help with the down payment or to avoid paying mortgage insurance altogether.
In the first case, the buyer doesn’t have the 3 percent to 5 percent down payment required by conventional and Federal Housing Administration loan programs. Taking a home loan from your retirement plan can make it possible for you to have the down payment money you need to buy a home.
In other scenarios, the buyer doesn’t want to pay the mortgage insurance, which is typically required when your down payment is less than 20 percent. Taking a loan from your retirement plan in this scenario can help you save hundreds of dollars per month on mortgage insurance.
When does it make sense to use a loan from a 401(k) in order to reduce the cost of homeownership?
There is a considerable difference between putting 5 percent down on a home, versus 20 percent down after borrowing from your retirement plan.
Consider a purchase of a $300,000 house with a 4 percent interest rate.
A 5 percent down payment is $15,000, meaning your loan will be $285,000, plus mortgage insurance. Mortgage insurance is typically between 0.5 percent and 1 percent of the entire loan amount on an annual basis. In this example, it’s likely around $120 to $238 extra per month. The total cost for mortgage insurance becomes $11,160 over 93 months, or seven years and nine months.
Your monthly payments to the bank will total $1,480 until the mortgage insurance drops off the loan, which brings it down to $1,360 monthly. Over the course of 30 years, you'll be paying the total of more than $500,000, assuming a 0.5 percent mortgage insurance amount.
If you have been able to save $90,000 in your 401(k), you're able to loan yourself up to 50 percent from your retirement savings (or $50,000 if you have more than $100,000 in your retirement). Added to other savings for a 20 percent down payment, your home loan is down to $240,000 and you will not be paying mortgage insurance. At a 4 percent interest rate your monthly payments to the bank drop to $1,145 monthly.
The total loan payment in this example is a little more than $412,000 over the course of 30 years with no mortgage insurance.
The caveat is that you still have to repay the $45,000 loan you took from yourself.
This means that you will owe yourself about $828.74 per month with a 4 percent interest rate over five years. Combined with your mortgage, your monthly payment becomes about $1,974. The benefit is that you are paying the bank $1,145 and yourself $828.74, instead of paying the bank the monthly total of $1,480.
So while you may be saving $335 per month you are also raising the total monthly payment from $1,480 to $1,974 over the five-year repayment plan. While this may seem like a considerable difference, remember you are paying yourself instead of the bank.
As you pay off loans, you build equity in your house over time. The historical average of real estate appreciation is 4.3 percent. This means that buying a $300,000 home with a 4 percent average annual appreciation will be worth nearly $1 million after 30 years.
When should you not borrow from your 401(k)?
Borrowing from your 401(k) should be a last resort. If it’s the only way you can afford to buy a house, it may make sense since real estate is also an effective form of saving for retirement.
Loan defaults are the No. 1 reason it may not make sense to borrow from your 401(k). If you quit your job or want to change careers you must pay the 401(k) loan back in full within 60 days of termination of employment. If you can’t pay the loan back in full within 60 days and you’re under the age of 59 and six months, you will be taxed on the amount withdrawn as well as an early withdrawal penalty.
When it comes to borrowing from your retirement plan, you are taking more than a loan from yourself – you’re also taking a risk. In many cases, the risk of being unable to pay back the loan will outweigh the benefits, so make sure you consult a professional before taking a loan from your retirement savings.
Teresa Mears | May 3, 2019
Conventional wisdom says 20%, but you can buy your first home with much less down.