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Published: Nov 22, 2022 14 min read
Real estate agent shaking hands with a young couple who just bought a house
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In addition to finding the best mortgage lender, saving enough money for a down payment on a house is one of the biggest obstacles prospective homeowners must overcome. The Federal Housing Administration (FHA) requires a down payment of at least 3.5%, and many lenders insist on a 5% minimum. Placing less than 20% down requires paying for mortgage insurance, which will increase your monthly payments.

With the average home price in the U.S. at $428,700 according to the Federal Reserve Bank of St. Louis, you might wonder if you can tap your 401(k) for a little extra help when buying a house.

Withdrawing from your 401(k) to purchase a home is possible, but using your retirement funds to become a homebuyer carries some risk. You should consider a few essential details before making a 401(k) withdrawal to cover a down payment or closing costs.

Continue reading to learn how to use your 401(k) to buy a house.

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How to buy a home using a 401(k)

If you decide to buy a house with your 401(k), you have two options: take out a loan or make a withdrawal.

Take out a 401(k) loan

Instead of taking money out of your retirement plan, you should first consider applying for a 401(k) loan for a home purchase. This option allows you to avoid paying the 10% early withdrawal penalty, and you won’t have to pay income tax on the amount borrowed.

Unlike a traditional loan, where you borrow money from a creditor, a 401(k) loan borrows money directly from your retirement savings account. Depending on the type of 401(k) plan your employer provides, you can take a loan for up to 50% of the balance or a maximum of $50,000 over one year.

Owing money to yourself doesn’t allow you to escape the usual trapping of taking out a loan. You still need to pay the money back within a certain period of time, usually five years, and will pay interest on the loan. The interest rate of a 401(k) home loan is typically one or two points above prime rates, which sits at 7% as of November 2022. Expect your loan rate to be in the range of 8% to 9%.

The interest rate of a 401(k) loan does not depend on your credit score, making this a tempting option for those with average or poor credit. Additionally, 401(k) loans don’t impact your debt-to-income ratio since the money comes from your retirement savings account. A 401(k) loan won’t impact your credit score, which could enable you to qualify for mortgage loans with lower rates.

Not every 401(k) plan offers a loan option. Check with your employer to determine whether you can take out a loan against your retirement savings account.

Make a withdrawal

The less desirable of the two ways to use your 401(k) for a down payment on a home is to withdraw funds from your retirement savings account. Unlike a loan, this option will likely come with a 10% penalty, and the money withdrawn is taxed like income.

The IRS usually considers taking out money early for any reason a hardship withdrawal, which can only be used to pay for an immediate and heavy financial burden. Examples of the type of expenses that qualify include:

  • Medical bills
  • Tuition payments
  • Funeral expenses
  • Costs associated with purchasing a primary residence, such as the down payment and closing costs

Determining whether borrowing from your 401(k) qualifies for a hardship withdrawal is up to your employer, not the IRS. You will need to provide proof of your current financial situation and inability to buy a home without the money from your 401(k). Even if you qualify for a hardship withdrawal, you will likely be subjected to a 10% early withdrawal penalty.

But can you use your 401(k) to buy a house without a penalty? Maybe. The government does allow exemptions when you use your 401(k) to buy a house, but qualifying for one is tricky. You’ll need to show that you have no other available assets that you might use to acquire the money needed to buy a home.

Additionally, qualifying for an exemption only removes the early withdrawal penalty. You will still be taxed on the amount withdrawn. Some 401(k) plans do allow for non-hardship withdrawals, but plans vary, and you will need to check with your employer to determine what your plan allows.

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The benefits and drawbacks of buying a house with a 401(k)

Pulling money from your 401(k) to buy a house seems like a natural fit. A 401(k) helps save for retirement, and owning a home provides additional stability and security, especially when living on a fixed income. If you’re wondering if you should use your 401(k) to buy a house, first consider these benefits and drawbacks.

The benefits

Tapping into your 401(k) account can provide the financial flexibility needed to buy the home of your dreams. If forced to pick between owning and not owning a home, you may find the decision to borrow from your retirement savings easy to make.

Advantages of a 401(k) loan:

  • Avoid paying penalties and taxes. Borrowing against your 401(k) account keeps you from paying early withdrawal penalties, and the money isn’t subject to taxation.
  • Avoid credit checks. Borrowing from yourself means avoiding credit checks lenders run that can negatively impact your credit score. Additionally, 401(k) loans are not listed as an existing debt on your credit report.
  • Potentially lower mortgage rate. Avoiding credit checks and traditional down payment loans leaves your credit score in the best possible position when applying for a mortgage. The higher your credit score, the better rate you can secure from a mortgage lender.
  • Default doesn’t affect credit score. Defaulting on a 401(k) loan won’t ruin your credit score, as failing to repay the loan won’t be reported to the three major credit bureaus.

Advantages of an early withdrawal:

  • Nothing to repay. Taking out a hardship withdrawal leaves you with cash and no additional debt. If paying back a 401(k) loan and a mortgage doesn’t fit within your budget, this option can provide financial flexibility.
  • Your credit score doesn’t matter. Individuals with average or low credit scores may find it difficult to secure money for a down payment, especially if they don’t own any assets they can use as collateral. An early withdrawal from your 401(k) plan doesn’t depend on your credit score, making it an option for those trying to rebuild their credit.

The drawbacks

A 401(k) loan or withdrawal for first-time home buyers is only sometimes the best option. Other opportunities to secure funding for a down payment carry less risk and may cost you less overall.

Disadvantages of a 401(k) loan:

  • Not always available. Not every 401(k) plan offers the ability to take out a loan. Check with your employer before making plans to borrow from your retirement account.
  • Old plans are ineligible. You cannot take out a loan against an old 401(k) plan from a previous employer unless you’ve already rolled that money into the plan offered by your current employer.
  • The repayment window shortens after leaving your job. Leaving your current employer shortens your repayment window, regardless of whether you leave voluntarily or are let go. You must repay the loan in full before the next time you have to file taxes, or else risk defaulting.
  • Defaulting costs money. Failure to repay on time will cause the IRS to reconsider the loan as a hardship withdrawal. You will then be assessed the 10% early withdrawal penalty and have to pay back taxes on the amount borrowed.
  • Your employer stops contributing. Any contributions an employer makes to your 401(k) plan will stop until the entire balance of the loan is repaid. This could represent a significant financial blow and alter your retirement plans.

Disadvantages of a hardship withdrawal:

  • You will lose more from your account than you'll gain in cash. Early withdrawals are taxed as income, which means you won’t receive the total amount you take out. You must account for withheld taxes to determine how much you need to withdraw to make the necessary down payment.
  • You lose 10% of the withdrawal amount. The IRS punishes early withdrawals by charging a 10% penalty if you don’t qualify for an exemption. That’s money you can't get back.

Your other options

Can you use 401(k) for closing costs and a down payment? Sure, but even with poor credit and little available cash, it’s important to consider alternative options before making any decisions.

Utilize an IRA

Individual retirement accounts (IRA) operate differently than employer-provided 401(k) accounts and include provisions for first-time home buyers. You can withdraw up to $10,000 from your IRA without penalty. You'll need to pay state and federal taxes on the money you withdraw, and any amount greater than $10,000 will trigger a 10% penalty. Since you’re withdrawing money from your IRA, you won’t have to repay the money you remove.

Obtain an FHA loan

Federal Housing Administration (FHA) loans are designed to eliminate many hurdles preventing first-time homebuyers from securing funding to purchase property. FHA loans require a lower down payment than non-government-backed lenders, but you must meet specific criteria to qualify:

  • The home must be your primary residence.
  • You must have a regular income and provide proof of employment.
  • Your debt-to-income ratio must fall below 43%.
  • A minimum credit score of 580 is required to qualify for a 3.5% down payment.
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Research down payment assistance programs

Some cities and local municipalities offer down payment assistance programs to enable first-time buyers to purchase homes within their communities. The rules governing these programs vary, and not every city will provide a program. You’ll need to research to determine if a program exists in your area.

The U.S. Department of Housing and Urban Development’s (HUD) website links to every state’s local resources, and is a solid place to start your search. The HUD site also provides information on the American Dream Downpayment Initiative, a government-sponsored program that helps low-income households afford a home.

Consider using your savings and investments

Taking out a loan to help cover the expense of a down payment and closing costs is more expensive than covering these costs out-of-pocket. If you have the money to pay in your savings account or can liquidate investments like stocks or bonds, you should consider covering the costs without a loan to avoid paying any fees or penalties.

Postpone buying a home and save up your down payment

Saving up the money to make a down payment in cash requires patience and discipline. But delaying homeownership until you’re in a better financial position can make homebuying less stressful and expensive.

How much of a 401(k) can you use to buy a house?

You can withdraw or borrow up to $50,000 from your 401(k) account over 12 months. The money can cover the down payment and closing costs of buying a home but cannot be used to make mortgage payments.

When using your retirement savings might be worth it

You should consider all other options before using a 401(k) account to finance your home purchase. The interest and penalty fees will substantially add to the cost of your home, and borrowing against your retirement savings can have severe financial consequences later in life.

However, if you need to buy a home and have no other option to secure funds for a down payment, borrowing against your 401(k) can provide the necessary cash. What is a 401(k) account if not a financial resource to be used to the fullest? If you need access to that money to buy a home, that alone may be reason enough to use your savings now rather than at retirement.

Weigh your options carefully

Buying a home is the most significant financial decision most people will ever make in their lifetimes, so take the time to carefully review your options. Consider scheduling a consultation with a home mortgage expert to learn more about costs associated with home buying and what types of home loans you may qualify for. Getting as much information on how to buy a house, in advance of applying for a mortgage, can help you avoid making costly mistakes.