For many Americans today, having inadequate savings to put toward a down payment is the predominant factor that prevents them from being able to purchase a home. This is particularly true among millennials. In lieu of spending years setting aside money for a down payment, another option is to take out a loan from your employer-sponsored retirement plan. A typical 401(k) loan allows you to borrow up to half of your account balance (up to a maximum of $50,000). In most cases, this amount must be repaid within five years, although that schedule can be extended if you are using the money for a down payment on a home. Before you borrow money from yourself, however, make sure you fully understand the pros and cons that are involved.
You Pay Yourself Back
Unlike a traditional home loan, where you borrow the money and pay it back to the lender, you’ll pay yourself back through payroll deductions (as an after-tax payment) or monthly savings. The latter, of course, requires a great deal of self-discipline on the part of the borrower.
Faster Access to Funds
Since the loan doesn’t have to be approved by a bank, you can usually access the money sooner than you would with a standard bank loan. Moreover, all of this is done without a credit check.
Lower Interest Rates
Interest rates may be lower than those associated with standard bank loans. In some cases, they may be half as much as what a bank might charge you for a personal loan.
Losing Your Job Will Result in Immediate Repayment.
If you lose your job, you’ll need to be prepared to pay the full loan amount back on very short notice. You are typically asked to do so within 60 days of your termination date. Any money that you do not repay will incur current income taxes, as well as a 10 percent early withdrawal penalty if you are under 59.5 years old.
You Will Have Less Freedom to Job Search.
“If you take out a loan from your current employer’s retirement plan, you may be less inclined to quit if a better job comes along,” says Megan Miller, a wealth manager at Harbor Wealth Management. “If you leave your job, you would be required to pay back the outstanding loan amount immediately. Otherwise, you’d be hit with current income taxes and the 10% early withdrawal penalty. This can be a disincentive for changing jobs,” she explains.
You’ll Forfeit Any Gains in the Market.
“Another pitfall is the lack of potential growth on the loan amount, as well as future contributions while you are paying back the loan,” Miller explains. Borrowing the money will remove it from investment in the market, and you would forfeit any gains from market increases during the loan payback period. “This can cost thousands over the long term,” Plus, the interest payments you make on the loan aren’t tax-deductible as they would be with a bank loan.
You May Be Biting Off More Than You Can Chew.
Miller suggests that borrowers first take a realistic look at their financial situation before taking a loan from their 401(k). “Taking out a loan from your 401(k) to purchase an asset may signify that you are living beyond your means. Borrowers may want to consider if the home purchase is really affordable for them, given they need to raid their retirement savings to finance it,” she cautions.
A retirement account loan can be a good option if you are in otherwise sound financial circumstances, but lack options for acquiring a down payment for your home. If you are considering purchasing a home and have questions about how you will finance your mortgage or fund your down payment, I would love to speak with you about your best course of action. Contact me at firstname.lastname@example.org or by phone at 303.579.5517.
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