When looking to buy and finance a home, the down payment has a major impact on your potential interest rates and monthly mortgage payment. While many programs allow you to buy a home with a smaller down payment, it is ideal to put down 20% to avoid mortgage insurance fees. Therefore, many people look to using part of their 401(k) to help with their down payment. While this is technically possible, there are many reasons we do not recommend doing so. In this article, we will explain what a 401(k) is, the cons of pulling from it for your home, and alternative options to come up with a strong down payment.
What is a 401(k)?
First things first, we will discuss what a 401(k) is. A 401(k) is a savings account specially crafted to help someone prepare financially for retirement. The benefit of a 401(k) account is that 401(k) holders can make their contributions to the account free of tax when they claim a tax deduction. In addition, their contributions will accrue tax-free interest over time. However, the account is strict and cannot be easily accessed.
As this account is specifically for retirement, withdrawals should not be made until 59 years of age, or when the holder is retired at 55 years of age (Experian). If the account holder withdrawals from the account prior to that, there is a 10% early withdrawal penalty of the quantity being withdrawn. In addition, the amount withdrawn is subject to income tax.
Why you shouldn’t use your 401(k) to buy a home.
With the strict regulations and structure of a 401(k), there are many reasons to not pull from this account for your home financing needs.
The first reason: penalty fees. When making a withdrawal from a 401(k) before the maturity date, there are penalty fees associated. In this case, 10% penalty will be charged on the amount of money withdrawn from the 401(k) account. Therefore, if you intend to take out $50,000, there will be a 10% penalty ($5,000) for the early withdrawal of funds. This means you may lose a good sum of the money in the account from withdrawing early.
In addition to this, withdrawing early will leave you in a worse financial position for retirement. Keeping your funds in your 401(k) ensures the compounding interest accrues for the entire balance of the account. By withdrawing funds from your 401(k), you’re reducing the compounding affect the account may have.
For example, over 25 years, $30,000 would become $162,000 dollars with a 7% annualization rate of return. Had you withdrawn $20,000 for a down payment, you would be left with $10,000 in the 401(k) account. Over 25 years, $10,000 would become $54,000 with a 7% annualization rate of return. There is a significant difference between $54,000 and $162,000 dollars.
Alternatives to finance your home.
Luckily, there are many alternatives to assist a strong down payment on a home. Some good alternatives are listed below.
You can consider withdrawing from your IRA account rather than your 401(k). An IRA account comes with specific provisions for first-time home buyers that could allow you to avoid any penalty fees.
FHA or VA Loans
FHA and VA loans allow you to finance a home with lower or no down payments. The exact mortgage rate and monthly payment are situational. Contact a loan officer to learn more about the variety of mortgage programs available.
Create a savings plan to save a certain percentage of your income, or designated amount each month. With this intention, you will be able to consistently build up savings for your down payment. We have two great plans to kickstart your savings journey:
- Check out this FREE 30-day financial wellness challenge to get your finances in order this month!
- Consider this very successful and popular budget we call the 50/30/20.
Gift funds are another great option that can be directly used for your down payment. A gift fund is a genuine gift from the donor and can’t be paid back as a loan. The donor cannot have any interest in the property that the fund is going towards, and there must be documentation of the donor’s transfer of funds into the recipient’s account. There are many guidelines and regulations for using and documenting gift funds – you cannot just come up with an undocumented large sum of money. Learn more about how to use gift funds specifically for a down payment.
Down Payment Assistance Programs
Another great option are down payment assistance programs, and we have many at Direct Mortgage Loans! Down payment assistance programs (DPAs) aid home buyers by providing grants, or loans, to reduce the amount needed for a down payment. There are many types of DPA programs, and each one comes with their own set of eligibility requirements. To find out what programs you could be eligible for, contact a loan officer today.
While it is legal to withdrawal money early from a 401(k) account and put that money towards a new home, it is not advisable. Luckily, there are many alternatives to sourcing a larger down payment for the purchase of a home. If you are interested in learning more about homebuying or finding out what options are available to you, contact us today!
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