Read this before using your 401(k) to buy a house

Gina Pogol
The Mortgage Reports contributor

Can I use my 401(k) to buy a house?

Using your 401(k) to make a down payment on a house is generally allowed.

There are even some benefits: 401(k) loans aren’t taxed, they don’t affect your credit score, and they have low interest rates.

However, borrowing from your 401(k) can do severe and lasting damage to your retirement savings. That’s why financial advisors recommend borrowers tap their 401(k) funds only as a last resort.

Before you decide to use your 401(k) to buy a house, consider the no- and low-down-payment mortgages available today.

Many people can buy a house with as little as 3% or even 0% down — so there’s a good chance you don’t need to tap your retirement savings to make a down payment. 

Verify your home buying eligibility (Jan 16th, 2022)

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You likely can’t use your 401(k) to buy a house flat-out since there are limits to the amount of money you can take out.

It is possible to use your 401(k) to cover the down payment and closing costs on a home purchase. But as most financial experts will tell you, using your 401(k) to purchase a home typically isn’t the best idea.

You have plenty of alternatives to your 401(k) to get cash for a down payment — ones that won’t have the same long-term ramifications as taking money from your retirement savings.

You can read up on other ways to get money for a down payment below.

But maybe you’ve already looked at all your options and decided the money in your 401(k) is the best way to get the cash you need to purchase a home.

In that case, there are two ways you can access your 401(k) funds.

  • You can take a loan from your 401(k) account, which will need to be repaid with interest
  • Or you can simply withdraw the money, which comes with a 10% penalty and income tax from the IRS

Here are the pros, cons, and rules for each method.

Verify your home buying eligibility (Jan 16th, 2022)

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

A 401(k) loan is the preferred method if you need to cash out some of your 401(k) retirement funds to buy a house. That’s because there’s a much lower cost associated with a 401(k) loan compared to a 401(k) withdrawal.

You should also know:

  • A 401(k) loan is usually not counted in your debt-to-income ratio, so it won’t hurt your chances of mortgage qualifying
  • 401(k) loans are not reported to credit bureaus, so applying for one won’t harm your credit score

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

Unlike a 401(k) withdrawal, a 401(k) loan is not subject to a 10% early withdrawal penalty from the IRS. And the money you receive will not be taxed as income.

The rules for using a 401(k) loan to buy a house are as follows:

  • Your employer must allow 401(k) loans as part of its retirement plan
  • The maximum loan amount is 50% of your 401(k)’s vested balance or $50,000, whichever is less
  • The loan must be paid back with interest (typically the prime rate plus 1-2%), on a schedule agreed to by you and your 401(k) provider
  • Typically, you cannot make 401(k) contributions while you have an outstanding 401(k) loan

401(k) loans typically need to be paid back over five years.

However, when the money is used to purchase a home, you’re usually allowed to pay it back over a longer period of time. Rules vary by 401(k) company, so check with yours to learn more.

Drawbacks to 401(k) loans for home buying

While you’re paying back the 401(k) loan, you usually can’t make new contributions to your retirement account. And that means your employer won’t be matching contributions, either.

All told, you could miss out on five years or more of retirement contributions — and five years of compound interest on those funds — which will likely make a big dent in your savings later in life.

If you leave your current company or are laid off while you have an outstanding 401(k) loan, the repayment period shortens. In that case, you’d have to repay the loan by that year’s tax filing date.

For example, if you take out a 401(k) loan on October 1, 2021, then leave your job on December 1, 2021, your entire loan would need to be repaid by April 15, 2022.

If your 401(k) loan is not repaid by its due date, the remaining balance is treated as a 401(k) withdrawal, meaning it will be taxed as income and subject to a 10% penalty.

Using a 401(k) withdrawal to buy a house

401(k) withdrawals are generally not recommended as a means to buy a house because they’re subject to steep fees and penalties that don’t apply to 401(k) loans.

If you take a 401(k) withdrawal before age 59½, you’ll have to pay:

  • A 10% “early withdrawal” penalty on the funds removed
  • Income tax on the amount withdrawn

For example, say you withdraw $20,000 from your 401(k) to cover your down payment and closing costs.

  • You’ll be charged a $2,000 (10%) early withdrawal penalty
  • And you’ll have to pay income tax on the $20K, which likely comes out to around $4,000-$6,000

That’s up to $8,000 gone from your retirement savings, on top of the initial withdrawal.

The standard rules for 401(k) withdrawals are as follows:

  • Most 401(k) plans allow withdrawals only in cases of financial “hardship”
  • However, using the money to buy a primary residence often qualifies as a hardship withdrawal
  • You can withdraw only the money required to cover your immediate need
  • The money does not have to be repaid

Since the IRS considers 401(k) withdrawals income, withdrawing 401(k) money could bump some home buyers into a higher tax bracket. This could add even more to the cost of the early withdrawal.

Coronavirus update:

The CARES Act provision allowing for tax-free withdrawals from a 401(k) expired on Dec. 31, 2020. The IRS’s normal 10% penalty is being enforced on hardship withdrawals in 2021.

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

Home prices keep rising — which means saving the required down payment to buy your first house can be tough.

But as a first-time home buyer, taking money from your 401(k) to buy a home is likely not the best option.

First-time home buyers are often at a key age for making retirement contributions. The more cash you put in when you’re young, the more time your money has to accrue compound interest.

By taking money out of your 401(k) to buy your first home, you can seriously reduce the amount in your savings when you’re ready to retire.

For example:

  • Say you have $30,000 in your 401(k) at age 30
  • After 25 years at 7% interest, that $30K will have grown to $162,800

Now imagine you take out $10,000 to make a down payment on your first home.

  • Your 401(k) now has $20,000 in it at age 30
  • After 25 years at 7% interest, it will have grown to $108,500
  • So $10,000 withdrawn now means $54,000 less in your 401(k) at retirement

This isn’t to say a 401(k) loan or withdrawal is always the worst option.

But before you turn to your retirement savings, consider all the other routes available for first-timers (or repeat buyers) to purchase a home.

Verify your home buying eligibility (Jan 16th, 2022)

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

Many homebuyers assume they need a 20% down payment, which can make it seem nearly impossible to save enough cash to buy a house.

But home buyers no longer need 20% down.

In fact, there’s a long list of low- and no-down payment home loans that can lower the barrier to homeownership.

Some of the most popular low-down payment mortgages are:

  • FHA loans — allow as little as 3.5% down and only require a 580 credit score
  • Conventional 97 loans — start at 3% down and require a 620+ credit score
  • VA loans — available to veterans and service members with 0% down
  • USDA loans — can be used in certain rural areas with 0% down
  • HomeReady and Home Possible loans — only require 3% down and have flexible requirements for first time home buyers who have little cash

But what if you don’t have a 3% down payment? After all, 3% of $300,000 is $9,000 — that’s still a lot of money.

If you need help making your down payment, there are other places to turn before your 401(k). For example: 

  • Look for down payment assistance programs in your area. DPA programs are available in every state. They offer grants and low-interest loans to help home buyers cover their down payment and closing costs. If you need help buying a house, DPA should be the first place you turn
  • Look for mortgage lenders that offer down payment or closing cost help. Some lenders have special programs that offer credits to cover part of your down payment and/or closing costs. Find a few examples in our list of the best lenders for first time home buyers
  • Ask a relative or family friend for help. Some home loans allow you to cover your entire down payment and closing costs using gifted money, although this must be properly documented. Make sure your real estate agent and loan officer know if you plan to use gifted funds

Most of these programs are specifically designed for first-time, lower-income, or lower-credit home buyers. So if you’re having trouble saving for a down payment for any of these reasons, there’s a good chance you could qualify. 

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

Most homeowners who put less than 20% down on a conventional loan pay ongoing private mortgage insurance (PMI) to secure the loan.

You could see mortgage insurance as just another expense of owning a home — along with property taxes, homeowners insurance, and maintenance.

But since mortgage insurance protects the lender and not the borrower, many home shoppers think they must avoid PMI at any cost.

Some home buyers resort to pulling from their 401(k) or IRA accounts to gather enough money for a 20% down payment and bypass the PMI requirement.

But does this plan really make sense in the long term?

PMI typically costs about 0.5% to 1.5% of the loan amount annually. On a $250,000 home loan, a 1% PMI premium would add $2,500 a year — or about $208 a month — to your mortgage payment.

Yes, that’s a lot of money. But PMI also has a great return on investment. Considering the equity you’ll build through homeownership, you could see a return on investment of over 500% — all while leaving your retirement savings untouched.

Taking a 401(k) loan or withdrawal, by comparison, sets you behind financially in a way PMI does not. 

In the example in a previous section, we showed how removing just $10,000 from a retirement account could result in a $50,000 lower balance at retirement.

Now imagine you remove $20,000 or even $30,000 to reach the 20% down payment mark to avoid PMI. The future losses are going to be way more impactful than the $200 per month outlay now. Don’t sacrifice your retirement savings because you’re averse to PMI. Look at the long-term, broader view.

Also remember you can cancel PMI after you pay off at least 20% of your conventional loan’s original balance. And if you have an FHA loan or USDA loan with permanent mortgage insurance, you could get rid of it by refinancing later on.

PMI is temporary, but the effects of pulling funds from your 401(k) could have permanent consequences.

Still not sure? Ask a financial advisor

For most home buyers, withdrawing or borrowing from 401(k) retirement funds to make a down payment on a house is short-sighted.

But your personal finances may create an exception. For some people, a hardship withdrawal or 401(k) loan could be a sensible solution.

A financial planner can help you weigh your current account balance against your long-term financial goals so you can better decide how to proceed. 

Consider using a Roth IRA instead

If you decide to use retirement funds to help buy a home, consider using money saved in a Roth IRA instead of a 401(k) or traditional IRA. Because Roth IRA contributions have already been taxed, you’ll have an easier time accessing this money.

Also, since money in your IRA isn’t connected to your employer, you won’t face a faster repayment period if you change jobs.

Do you qualify for a mortgage without 401(k) funds?

With such a wide range of mortgage options and down payment assistance on the market, most people simply don’t need to tap their 401(k) in order to purchase a home.

On top of that, today’s low mortgage rates increase your home buying power by reducing monthly payments. It’s easier to afford a home than ever before.

Before taking money out of retirement, find out whether you qualify for a mortgage based on your current savings. You might be surprised.

Verify your new rate (Jan 16th, 2022)