Borrowing From Your 401(k) to Finance a Home

Borrowing from your retirement plan to fund a down payment isn't a ter­rible strategy, especially if you want to lock in today's superlow mortgage rates (the recent average for a 30-year fixed-rate mortgage was 3.5%). Now that no-down-payment loans are a thing of the past, borrowing from a 401(k) has become a popular option. Some 9% of recent home buyers used funds from a 401(k) plan or pension for a down payment, according to a 2012 report by the National Association of Realtors.

When you borrow from your 401(k) plan, you pay interest to yourself. The rate is typically one or two percentage points above the prime rate, which is currently 3.25%, and you can usually borrow up to half of your balance, or a maximum of $50,000. Most loans must be repaid within five years, although some employers will give you up to 15 years if the money is used to buy a home.

Unlike some other types of debt, a 401(k) loan won't count in your debt-to-income ratio when you apply for a mortgage, says Frank Donnelly, president of the Mortgage Bankers Association of Metropolitan Washington. That's because the loan is secured by the money in your 401(k) plan, he says. Also, 401(k) loans aren't reported to the credit bureaus, so the debt won’t hurt your credit score.

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Think twice. If you fail to repay the loan, it will be treated as if you made a taxable withdrawal from your plan. You'll have to pay income taxes on the balance, plus a 10% early-withdrawal penalty if you're under 59½. Likewise, if you're laid off or fired from your job or you quit, you generally have just 60 to 90 days to pay off the outstanding loan. Otherwise, the balance will be taxed, and you'll owe a 10% early-withdrawal penalty if you're under 55 when you leave your job.

And even though you're paying yourself back, the loss of earnings growth could leave a gap in your nest egg. Suppose you borrow $50,000 from your 401(k), repay it at 4.5% interest over five years and retire in 35 years. If the average rate of return on your investments is 8%, the loan will reduce your retirement savings by $50,000. (You can run other scenarios with the retirement loan calculator at Bankrate.com.)

The dent will be even deeper if you suspend or reduce contributions to your 401(k) while you're paying off the loan. And the tax code doesn't work in your favor: You repay the loan with after-tax dollars, and you'll pay taxes on that money again when you take withdrawals in retirement.

One alternative is to apply for a mortgage with a lower down payment, says Erin Lantz, director of Zillow Mortgage Marketplace. Loans backed by the Federal Housing Administration require a down payment of 3.5%, and some lenders offer loans with down payments of 10% or less.

The trade-off is that you'll probably pay a higher interest rate than you would with a 20% down payment, and you'll have to buy mortgage insurance. Private mortgage insurance premiums range from 0.5% to 1.15% of your loan amount. PMI usually remains in effect until you have at least 20% equity in your home. Annual mortgage insurance premiums for FHA loans are higher -- 1.35% for most loans -- and remain in effect for the life of the loan.