Borrowing from a retirement plan to buy a home might seem like a great way to get into the world of real estate. Of course, there are many benefits and disadvantages to this approach. With the answers to these questions, potential home buyers will understand the difference between borrowing and withdrawing from various retirement accounts.
1. Why Borrow from Retirement for a Down Payment?
For people with little savings to use to buy a home, the costs of getting a mortgage can be somewhat difficult. A large down payment might be as much as the average yearly household income, depending on the area. There are plenty of low down payment options for qualified applicants. However, buyers who only put 3–5 percent down could find themselves stuck with hundreds of dollars in private mortgage insurance payments for years. In some cases, it might make more sense to borrow from retirement savings in some form to help shoulder the initial costs of buying a home.
2. How Does Borrowing from a 401k Work?
Borrowing from a 401k typically involves borrowing against the money that is already in the account. The payment is structured much like any other secured loan, with a set monthly payment and a specific term (usually limited to five years). The borrower receives money and then pays back the principal and interest, effectively to themselves. Interest rates may be similar to mortgage interest rates. They may decide to repay the loan in a lump sum when they can, or make those monthly payments regularly.
3. Is There a Maximum Amount People Can Borrow?
Borrowing against a 401k is not the same as simply withdrawing the money, so there are limits to the amount that people are allowed to borrow. The maximum amount is often set at $50,000 or half of the total in the account, whichever number is lowest. This means that a person who has $80,000 in a 401k may be able to borrow up to $40,000. By comparison, a borrower with only $10,000 in a 401k could be limited to $5,000.
4. Could It Affect Mortgage Eligibility?
Any time people borrow money, they should keep in mind how it will appear on a mortgage application. Credit scores usually reflect a person's utilization of debt to available credit, but mortgage loans also consider an applicant's ratio of debt to income. Although people who borrow against a 401k are technically loaning themselves the money, it is counted as a loan on mortgage applications. This underscores the importance of minimizing the amount borrowed. A loan that has a monthly payment of several hundred dollars could seriously limit a person's borrowing power, if it causes their debt-to-income ratio to exceed standard limits.
5. What About Cashing Out a 401k for a Down Payment?
Many people choose to borrow against a 401k instead of simply cashing it out, largely due to tax reasons. Anyone who cashes money out of a 401k before they are 65 years old may have to pay taxes on the withdrawal, on top of a 10 percent early distribution penalty. Withdrawing from a 401k to buy a home counts as a “hardship distribution,” which means that people might not have to pay that penalty. However, cashing out a 401k should still be considered a possibly risky proposition. People should weigh the long-term gains they might lose from spending that money before they decide if it is ultimately worth it.
6. Can People Take Withdrawals from an IRA?
If people have an independent retirement account, they may choose to withdraw some of the money in that account to cover part of the cost of a down payment. The limits and rules concerning IRA withdrawals relate to the type of IRA. Since people have already paid taxes on their contributions to a Roth IRA, they may withdraw that money whenever they like with no penalties or taxes owed. If the Roth IRA is at least five years old, they may also be able to withdraw up to $10,000 of earnings on that account, tax-free. Home buyers who withdraw from a traditional IRA for a down payment on a home may be exempt from the standard 10 percent penalty for early withdrawals. Each person can take out as much as $10,000, which is a lifetime cap. They will, however, be responsible to pay taxes on withdrawals from a traditional IRA.
Getting into a home usually starts with a sizable down payment. People may benefit from borrowing from certain retirement plans to help them get started, but they should understand all the details before they make a decision while buying an Old Town Alexandria home.