While the vast majority of Americans would like to own a home, nearly 70 percent of potential buyers feel that a down payment is the greatest obstacle to making that a dream a reality.
If you’re in that camp, you may have considered borrowing against the balance of your employer sponsored retirement account to cover the upfront cost of a home. Using a 401(k) loan for a down payment can be an attractive option, but it’s important to understand the potential risks before making the decision to take one on.
How a 401(k) loan works
According to the Employee Benefits Research Institute, 53 percent of 401(k) plans include a loan provision that allows participants to borrow against their savings. With a 401(k) loan, you can borrow up to half of your account balance or $50,000, whichever value is smaller. So if you had a balance of $70,000 you could borrow up to $35,000; with a balance of $170,000, you could borrow up to $50,000.
The loan must be repaid, with interest, in monthly or quarterly installments. You’re typically required to repay the loan in full within five years, though the payback period can be longer if the loan is used for a down payment on your primary residence.
There are several advantages to this approach. Because you’re not borrowing from a financial institution, you don’t need to undergo a credit check to receive approval, and you can typically receive your money faster than you could through the traditional application process. In addition, you’re paying principal and interest to yourself, rather than a bank. Also, interest rates are relatively low (typically around two points above the prime rate).
The risks of borrowing from a 401(k)
Borrowing from yourself rather than a bank may have some advantages, but it’s not without some substantial risks. Fail to make a payment within 90 days and the amount you borrowed is considered a distribution from the account and taxed as income. If you’re under age 59½, you’ll pay an additional 10 percent early withdrawal penalty on top of those taxes. What’s more, if you leave or lose your job before the loan is settled, you’ll be forced to pay the entire outstanding balance within 60 days
And then there’s the more subtle, but more significant long-term consequence: By borrowing from your retirement savings, you’re losing out on the possibility of compounding interest on that money. To make matters worse, people who take out a 401(k) loan often decrease or even stop contributions to their retirement account during the years they’re repaying it. Those factors can have a tremendous negative impact on your savings.
Is a 401(k) loan the right option?
Given the potential risks, a 401(k) loan should be a last resort for most people. If you don’t have enough in traditional savings, you might explore financial assistance programs and grants through national Housing Finance Agencies or your state and local government, or even financing through consumer or peer-to-peer lending.
If you do think a 401(k) loan could be the right option for you, start by talking with your HR representative or plan sponsor about whether loans are allowed, as well as the details of financing including the interest rate and repayment schedule. From there, the process of initiating the loan is very simple—you file a request with the plan administrator and once they’ve approved the loan, the plan custodian either sends you a check or makes a direct deposit into your account.
A home can be a great investment, but think hard before you leverage your retirement savings to help pay for one. And if you do decide to borrow from a 401(k), remember to keep contributing to your retirement savings so that your shorter-term goals don’t derail your longer-term financial plans and security.