How to Use Your 401K for a Down Payment 

Working towards buying your dream home and feel like you just can’t wait anymore? Even if you have everything in line—you’ve built up your credit score, found a great home within your budget, maybe you’ve even started shopping for loans. At some point, though, you’ll realize that you might need quite a hefty down payment.

 

Before you come close to signing for your home, you’ll probably be asked multiple times about what assets you have. And maybe a 401k is one of them. Does that mean you can use your 401k for a down payment? You can, but you might not have to. And it’s best that you don’t. Here are some points worth considering.

 

Coming up with a down payment on a home

You’ll often be told that you need at least a 20 percent down payment on a home. While this is true for many conventional loans, it’s not always the case. And if you go with an FHA loan instead, your down payment could be as low as 3.5 percent. There are a couple of things you should know in advance, though.

 

With a low down payment, you’ll end up having higher monthly payments. This is for two reasons. The first is that you’ll owe more on the home overall. The second is that you’ll have to pay more for mortgage insurance. Mortgage insurance is a monthly fee that helps protect lenders should a borrower default on a payment. While conventional loans either require no mortgage insurance or mortgage insurance until you’ve paid off a certain amount of your loan—FHA loans require mortgage insurance for the entire duration of your loan.

 

In general, mortgage insurance is about 0.5–1.5% of a loan amount per year. So for a $250,000 loan, mortgage insurance would cost around $1,250–$3,750 annually or $100–315 per month.

 

Using a 401k for a down payment

Why not just use your 401k for a down payment instead of paying extra money every month? You can probably break down the cost and benefit analysis to make it more specific to your situation if you're good at math. You may save more money by using your 401k, but it’s unlikely. That’s because you’ll have to pay a 10 percent fee on the amount of money that you take out. You’ll also have to pay federal and possibly state taxes on the money since it has technically become a part of your income for the year.

 

Let’s say that you pull $20,000 out of your 401k for a down payment. You’ll have to pay a $2,000 fee for taking money out before the age of 59.5. Now let’s assume that you make $40,500 a year, and normally, you’re in a federal tax bracket that requires you to pay 12 percent of your income in taxes. But you must now add $20,000 to your total income amount. That means your total income would equal $60,500. That puts you up to the next bracket, meaning you’ll now have to pay 22 percent of your income in taxes. If you live in a state where you have to pay state taxes, that’s at least another 12 percent.

 

Take a look at the table below to see what using a 401k for a down payment might cost you.

 

 

12%

22%

Federal taxes on salary

 

$4,860

$8,910

Federal taxes on 401k withdrawal

$2,400

$4,400

Early withdrawal fee

$2,000

$2,000

Total cost with taxes

$9,260

$15,310

 

In this scenario, you’re withdrawing $20,000 from your 401k, but you’re only getting $13,950 after taxes and penalties. That’s a $6,500 loss.

 

These figures don’t include your opportunity costs. A 401k earns about five to eight percent in returns each year. And the earlier you invest, the better. A 25-year-old who invests $5,000 a year with an eight percent average annual return for 43 years would have approximately $1.65 million saved. If you started saving ten years later and invested $5,000 per year with the same eight percent average annual return, after 33 years, you would only have saved approximately $729,750.

 

This all sounds intimidating, but you shouldn't let that scare you away from buying a home. You don’t have to be a first-time homebuyer to qualify for an FHA loan. And while paying mortgage insurance doesn’t sound like the best deal, it could be better than spending much more on rent. Just be careful before you decide to use your 401k on a down payment—make sure to explore your other options and crunch some numbers first.

 

Keep in mind that many programs are available to help buyers with student loans or support first-time buyers who are still building up credit and savings. And if you get preapproved for a mortgage, you’ll have a better understanding of how much home you can afford and how much of a down payment you’ll need long before closing.

 

Looking for more Foundation tips and learning? Return Home here.

Published 03.18.22

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