Does it make sense to withdraw your 401K to buy a home? Even though it is an option, it’s not one we generally recommend. To understand why, let’s start by talking about the 401K itself.
What is a 401K?
As you most likely know, the 401K is a retirement savings vehicle. It gives employees a pre-tax opportunity to save money for retirement. Even though you have to pay taxes on it later when you withdraw from it, it’s one of the best ways for most Americans to fund the golden years. If you withdraw from your 401K before you’re of age, you usually have to pay a hefty penalty.
One exception to this rule is if you buy a home. At this time, the government does allow you to use your 401K to help with your down payment. Since a down payment is something most new homebuyers have trouble coming up with, this can sound like a great opportunity.
Are There Advantages to Using a 401K to Buy a House?
Sure. One good thing is that your 401K loan won’t be counted on your debt-to-income ratio. That means it won’t negatively affect the interest rate you get from a lender.
Another good thing about going down this path is it can help you avoid private mortgage insurance (PMI.) PMI adds up over time and it’s a major thorn in the side of many homeowners. Knowing they can avoid this fee by withdrawing from your 401K is very appealing to these folks.
However, just because there are advantages to this doesn’t mean it’s the right way to go. Let’s consider a few downsides.
Cons of Using a 401K for a Down Payment
The first con to withdrawing your retirement money for your house is it breaks the mental “piggy bank” you have around your retirement savings. Most of us don’t even consider taking money out of our retirement fund, just because we know that money has a purpose. You put it there for a reason, and taking it out will set you behind on your goals and can start a bad habit of thinking it’s available for you to use now.
It’s kind of like if you go on a diet for a while then have a cheat meal. That cheat meal opens up a door for another cheat meal, and before long you’ve had a cheat week!
Something else to consider is the opportunity cost. Let’s examine 2 scenarios:
- Scenario 1 is that you take $50,000 from your 401K to boost your down payment. That way you don’t have to borrow as much in the mortgage at 3% interest.
- Scenario 2 is you leave the $50,000 in your retirement account. It continues to grow at 9% annually, and is sheltered from taxes until you take it out in 30 years.
So you’re essentially comparing saving 3% interest vs. growing at 9%. Over the course of 30 years, the numbers will heavily favor the idea of keeping money in your 401K.
There’s no black-or-white answer to this question unfortunately. If withdrawing your 401K helps you avoid PMI, it may be worth it. But keep in mind there are downsides to this path. For some more personalized advice, please reach out at (949) 651-6300 and we can guide you through this process.