5-11-18: Should I use funds from my 401(k) to buy my new home?
Question of the week: Should I use funds from my 401(k) to buy my new home?
Answer: This is a great question that has come up a few times recently as home prices continue to climb and for many families down payment is a barrier to home ownership.
“Should” is the key word, and as with most of our questions of the week the answer varies from person to person, family to family.
Before we answer “should,” let’s answer “can.”
If you have a 401(k) retirement account through your employer it has several rules, regulations and policies as to how the your account must be handled, including access to funds. Since the money was put into the account before taxes, all the money in your account has accumulated with no taxes being paid. Therefore when the money does come out of the account it will probably be taxed, unless the money is borrowed to be repaid and you do not violate any of the rules and policies of either the plan or the IRS.
Most 401(k) plans allow loans to participants for hardship, medical or education costs and the purchase of a primary residence. Note, “most,” so your plan may not allow loans. One of the provisions of any 401(k) loan is that if it is not repaid on time you will be subject to taxes, and penalties if you are under 59 ½ years of age.
Assuming your plan allows you to borrow money for the purchase of your home, here is how it usually works.
The maximum amount allowed to be borrowed is either $50,000 or 50% of your 401(k) balance, whichever is less.
You must repay the loan with interest that is paid to yourself, at a rate that is set by your 401(k) policy, typically Prime + X. So if your plan has the interest on the loan is Prime + 1 today your rate would be 4.75% + 1 = 5.75%.
The term of repayment varies from plan to plan, most plans have a maximum repayment period of five years, with exceptions for home loans that can be up to ten year amortization periods.
Your repayment is made via your paycheck with after tax dollars. You can, and should, continue to make 401(k) contributions during your repayment period.
If your employment terminates and there is a balance due on the loan you either need to repay the balance or face tax consequences on the unpaid balance. For instance, you are offered a job with another company that is a fantastic opportunity, but you have a $6500 balance due on your 401(k) loan. Your options are to leave the company and roll the 401(k) into another account, either the 401(k) with your new employer if they allow it, or into a rollover IRA, without repaying the loan. In this case the $6500 will be taxable and if you are under 59 ½ you will have a penalty. Or, you can contact the plan administrator, find out who and how to make out a check and pay off the loan, and then transfer the account. Most plans allow you 60-90 days to make arrangements for your employer sponsored retirement account.
The funds for your loan are taken from the funds, or investments, within your 401(k) at your direction. You are borrowing $25,000 for the purchase of your new home, and you have your 401(k) invested in four different mutual funds and company stock. You direct your administrator to take $5000 from each of the funds and the stock account to fund your loan. As you repay the loan most plans allow you to direct the payments back into the funds from which they were taken in the same proportion to which they were liquidated, so your account allocation will still be the same as before the loan was funded.
Now that we know the “how,” let’s look at the “should.”
There are many that argue against borrowing from your 401(k) for any reason, and there are many that argue it is not a bad idea, and in fact can be a good idea. For disclosure purposes, I purchased my first home by borrowing $7500 from my 401(k) for the down payment. It was one of the best financial decisions I ever made.
One argument, and perhaps the one made most frequently, against borrowing the money is that you lose the growth opportunity of those funds invested in the market and growing tax free. This is true, if you take $25,000 from your 401(k) those funds are not subject to any market growth or dividend reinvestment while they being repaid; this also means that the funds are not subject to any declines in market value while they are outstanding. Lost in this argument is the interest you will be repaying yourself. If the interest rate you are paying is equal to or greater than market performance plus and dividends then there is no net loss to your account during the period. If the market grows at a significantly greater rate than your interest rate on the loan then your opportunity costs are the gains in your investments less the percentage you are paying.
Also lost in this argument is the accumulation of equity in the home you are purchasing during the period to loan is outstanding. So the true cost, or benefit of the transaction is the difference between the gain in value of the funds in your 401(k) less the combined gain in market value of your home plus the rate of interest on your 401(k) loan. As an example, the $7500 I borrowed to purchase my first home resulted in substantial equity growth that we then used to purchase our current home—the $7500 invest in 1994 is worth considerably more today than the growth of $7500 in the market during the time period.
Another argument against borrowing against your retirement account to purchase a home is that you are hurting your retirement. This may be true depending on your age and how long until you retire, how much you borrow, whether you are able to repay the loan before retirement to avoid a large tax liability, and what is the status of the home you purchase. If you are young, working for a long time and are able to repay the loan with plenty of time until your retirement and your home value rises then you are not worse off, in fact may be better off, by purchasing your home by leveraging your retirement account.
Bill and Sue are in their late 30’s, have been unable to purchase a home as they do not have enough money saved for down payment and closing costs. They each borrow $25,000 from their 401(k)’s and purchase a $500,000 with 10% down payment. They are able to repay their respective loans in five years. In twenty years when both kids are out of college they are getting close to retirement. Their home is not paid off, they took out some equity for college costs, but they have a lot of equity. They plan on retiring in about five to ten years and looking at their home value, and costs for homes near where both their kids are living, discover they will probably be able to sell their home and purchase their retirement home without needing a mortgage. They enter retirement with no housing cost—typically the primary cost in retirement—except property taxes and insurance, and retirement accounts that have grown during their years of employment.
Some of the advantages of 401(k) loans used to purchase homes. There are usually no transactions costs, perhaps a $25 processing fee. Most loan programs do not count a 401(k) loan repayment against you for qualifying purposes. There is no qualification process for the funds, as long as you have the money in your account and the plan allows it you can borrow it. Funds are usually available within two weeks or less of your reqest.
Should you borrow from your 401(k) to purchase your new home? Maybe. Give me a call to discuss your situation and I can help you make that determination.
Have a question? Ask me!
Inflation concerns are a bit abated with the Producer and Consumer Price Index data from April, both of which were lower than expectations. On the wholesale side PPI showed 0.1% growth in the month and is up 2.6% year over year. For consumers the CPI was up 0.2% for the month and 2.5% for year. With the tame inflation data for April, investors’ concerns about inflation forcing rates up are dampened and the data announcements had no impact on rates.
Rates for Friday May 11, 2018: Week to week we are flat once again, three Fridays in a row with the same rate shows some rate stability and what is probably the new “normal” for mortgage rates.
FIXED RATE MORTGAGES AT COST OF 1.25 POINTS LOCKED FOR 45 DAYS:
30 year conforming 4.50% Flat
30 year high-balance conforming 4.75% Flat
Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, no impound account and period rate is locked. Rates are based on 20% down with 740 FICO score for purchase mortgages.
Spoil the moms! Your own, your children’s, your neighbor’s, your brother in-law’s, spoil them all this weekend. And remember what my mom always said, “every day should be mother’s day, not just one day a year…”
Have a great week,
Dennis
