Applying for a mortgage loan means lenders will take a close look at your financial situation to gauge your creditworthiness. One thing lenders consider is your debt-to-income (DTI) ratio, or how much of your income goes to debt repayment each month. If you have a 401(k) loan, you might be wondering whether that counts as debt for DTI calculations. The short answer is usually no, though it’s important to understand how lenders view your 401(k) for mortgage approval.
A financial advisor could help you put a financial plan together for your home buying needs and goals.
401(k) Loan Basics
A 401(k) loan is a loan you take out against your retirement savings. IRS rules allow employees to borrow up to 50% of their vested 401(k) balance or $50,000, whichever is less. This money is then paid back through salary deferrals over a period of five years with interest.
Taking out a 401(k) loan is something you might consider if you need money to cover a financial emergency, consolidate debt or manage another large expense. Getting a 401(k) loan may be easier than getting a personal loan, for instance, since there’s no credit check involved. And the interest rate you pay might be lower than what you’d get with a personal loan.
Of course, there are some potential downsides. Borrowing money from your 401(k) means that money doesn’t have an opportunity to grow through the power of compounding interest. That could affect your retirement outlook if you reach the end of your working years with less money than you anticipated. You’re paying yourself back but you can’t replace lost growth.
There may also be tax repercussions associated with a 401(k) loan. If you leave your employer before the loan is paid off, the remaining balance becomes payable immediately. If you can’t pay off the loan, the full amount is treated as a taxable distribution. You may also owe a 10% early withdrawal penalty if you’re under age 59 ½.
Do 401(k) Loans Affect Mortgage Applications?
Mortgage lenders use the DTI calculation to determine your ability to repay a mortgage loan. Generally, lenders follow the 28/36 rule for estimating debt-to-income ratios. This rule states that housing should account for no more than 28% of debt repayment each month and your total DTI should be no higher than 36%.
So, do 401(k) loans affect mortgage applications where DTI is concerned? Generally, no. Mortgage lenders may acknowledge that you have a 401(k) loan but they don’t necessarily treat it as a debt the same way they would credit card payments or loan payments. That’s because you’re paying back yourself, rather than a lender or creditor.
If a mortgage lender does include 401(k) loans in DTI calculations, the effect it has on your mortgage application can depend on how much you borrow, how large of a mortgage you’re trying to obtain and any other debts you have.
If your DTI is already on the low side because you’ve paid off your student loans and you don’t have any credit card debt, then a 401(k) loan may not move the needle much. On the other hand, if you’re already carrying a high debt load, then a lender might see a 401(k) loan as an additional risk factor when gauging your ability to repay a mortgage.
401(k) as an Asset for Mortgage Approval
In addition to reviewing your liabilities, mortgage lenders also look at your assets to decide whether to approve you for a home loan. A 401(k) is usually included on the list of assets mortgage lenders look for, alongside bank accounts and other savings.
Any money you have in your 401(k) could be treated as an asset, less anything you owe toward a 401(k) loan. So if your total account balance was $500,000 and you borrowed $50,000 via a 401(k) loan, the remaining $450,000 could still count be counted as an asset.
That could work in your favor for mortgage approval since it shows lenders that you do have resources you can draw on to pay your home loan if necessary. You could take out a loan, or if your plan allows it, a hardship distribution. With hardship distributions, you pay no early withdrawal penalty but you’ll ordinary income tax on the amount you take out.
Can You Use a 401(k) to Buy a Home?
Getting a mortgage means you’ll need to put something down. The amount you need can depend on the type of mortgage loan you’re getting and the amount you plan to borrow. If you don’t have enough cash to cover the down payment, you could borrow against your 401(k).
Mortgage lenders do allow borrowers to take out 401(k) loans to fund the down payment. Again, you’re limited to borrowing 50% of your plan’s vested balance or $50,000, whichever is less. Your plan administrator may require documentation stating that the money is to be used toward a down payment. The lender may also require you to deposit the money into a separate bank account for holding until you’re ready to close.
Whether it makes sense to use a 401(k) loan to fund your down payment can depend on your financial situation. You might want to hold on to your cash reserves, for example, if you know you’ll need to make some repairs or improvements in order to move into the property. Or you may not have enough cash to cover all of the down payment.
Also, consider whether you’ll be able to make new contributions to your 401(k) while you’re repaying the loan. Some plans allow this; others don’t. Making your regular contributions while also paying back the loan and meeting your other financial obligations could put a strain on your finances.
A 401(k) loan shouldn’t affect your mortgage application—though if you’re concerned about it you can ask your lender whether it will be included in your DTI calculation. If you have a 401(k) loan and you’re worried about being denied for a home loan, you may want to work on paying down some of the balance first. That could help to bring your DTI into an acceptable range and it makes your 401(k) a larger asset, both of which could make it easier to get a mortgage.
Mortgage Planning Tips
- Consider talking to your financial advisor about the pros and cons of 401(k) loans if you’re planning to buy a home. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you have an Individual Retirement Account (IRA), you could also consider using it to fund your home buying goals. The IRS allows you to withdraw up to $10,000 from your IRA toward the purchase of a first-home penalty-free. If you’re withdrawing original contributions from a Roth IRA, those amounts are also tax-free as well. That may be a better alternative for meeting your down payment needs if you’d rather not borrow from your 401(k).
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