401k For Down Payment
With all of the underwriting guideline changes in the mortgage industry, it is more important than ever to save for a down payment when purchasing a new home. A lot of people are considering turning to their 401(k) investments to supply their down payment. Before doing this, however, there are a few things that the borrower must consider.
Losing the Benefit of Compound Interest: Albert Einstein said, “The most powerful force in the universe is compound interest.” 401(k) accounts grow with compound interest from tax free dollars. If a borrower withdraws money from his or her asset account, they are lowering or losing the benefit of having their money grow exponentially from compound interest.
Hardship Withdrawals: Many employers allow for their employees to make a one time “hardship” withdrawal from their 401(k). This withdrawal includes covering funds for a down payment on the employee’s primary residence, however, the money is subject to taxes and penalties once the money is withdrawn. Because the borrower is only allowed to make such a withdrawal one time, it is usually best to save this option for a time of emergency or illness.
Loans: The employee may also have the option of taking out a loan against their 401(k). This loan, like any other, may be charged interest and the re-payment schedule can be any where from five years to thirty years. Because it is a loan, the funds borrowed are not taxed when they are taken out of the 401(k), but the new payment may be considered as part of the borrower’s debt-to-income ratios, just like a car or credit card payment might. Also, where a 401(k) will roll over to another employer if the employee changes jobs, the loans against the 401(k) will not. In fact if an employee changes jobs, he or she may have to pay back the loan as soon as three months after leaving their first position. Otherwise, the loan will be considered a withdrawal and will be taxed and penalized.
Finally, one of the qualifications for approving a potential home buyer is the buyer’s capacity to save. A 401(k) statement is a great way to show reserves–that is money saved as a buffer in case of income interruption. If a borrower depletes his or her 401(k) to cover their down payment, and does not have another account to show reserves, then the borrower may hurt their chances of getting approved for the mortgage loan. An underwriter won’t approve a loan if it looks as though the borrower is over-extending themselves.
In the end, it is better to own a home than to not own a home. But, using 401(k) retirement funds should be a buyer’s last resort for a down payment. If the buyer does choose this route, they should make certain that they understand the terms, conditions, taxes and penalties of dipping in to their investment account.
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