Where to get the money for a down payment on your house? As prices increase faster and faster, the amount needed for the optimal 20 percent down payment (to avoid monthly mortgage insurance) gets bigger. Meanwhile, if you have been in the workforce for a number of years, you probably have a substantial nest-egg built up in a 401(k).
Find out now: How Much Should I Put Down?
I Don’t Want to Tap into my Retirement Savings
Conventional wisdom suggests that you should not touch the money that has accumulated in your 401(k) until you reach retirement age. The tax advantages of putting money away in a 401(k) are lost if you pull the money out early. What’s more, the fund in which your money is invested will usually charge you their own early withdrawal fee.
While buying a home could be the biggest (and best!) investment you will ever make, having a healthy 401(k) is a key part of your long-term financial plan. Gutting your 401(k) now could leave you ill-prepared for retirement.
Find out now: How Much Do I Need to Save for Retirement?
Fortunately, there is a way to take advantage of the savings in your 401(k) without sacrificing your long-term plan.
Borrowing from Yourself
Taking out a loan against your 401(k) rather than doing a straight withdrawal is a great way to increase your down payment amount.
While there are a number of ways you can borrow the money needed for a down payment, with a loan against your 401(k), you will be paying back the principal and interest on the loan to yourself, not to some other bank. Rates are usually comparable to mortgage rates, and since the principal is, again, borrowed from yourself, you have a variety of repayment options, from monthly payments, to lump sums.
A 401(k) Loan vs. Mortgage Insurance
Lets look at two possible scenarios for a purchase of a $300,000 home:
Suppose you have $15,000 in cash for a down payment. You have a credit score of 700. If you take out a mortgage at $285,000 at 5 percent interest, your monthly payment will be $1,530. But with a loan to value ratio of 95 percent, your monthly mortgage insurance cost will be around $220. Your total monthly obligation would be $1,750. This would be the payment for the first five years, until the mortgage insurance dropped off.
Related Article: Why and When You Should Borrow Against Your 401(k)
If you have a 401(k) worth at least $90,000, you can borrow up to 50 percent of it, allowing you to only take a mortgage loan of $240,000 (80 percent of the purchase price) and avoid mortgage insurance. The mortgage payment would be $1,288. In this scenario, your 401(k) loan will be for $45,000.
If your 401(k) loan is also at 5 percent interest, on a typical five year repayment, your payments to yourself will be $850. This makes for a total monthly payment in the first five years of $2,138. While this is significantly higher than in the scenario with mortgage insurance, remember that the $850 is coming straight back to you and your retirement account. After the five years are up, your monthly payment for the remaining 25 years of the loan would be almost $250 less than in the first scenario.
Financing a home with a 401(k) loan is not for everyone. Obviously, if your monthly income can barely support your mortgage payment as it is, taking on a five year payment on a 401(k) loan will be difficult. Even if you are able to structure it with a lump sum payment, you will still have to qualify as if you were making monthly payments. But for home buyers with good cash flow and minimal non-401(k) savings, this plan could be the perfect way to finance your new home.
Related Article: What is the Typical Down Payment on a Home Purchase?
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