If you need extra financial assistance when buying a house, you may consider using the funds in your 401k. This can be an untapped resource if left unused, but it can also end up putting you further into debt or, in some cases, reducing the size of the mortgage you qualify for. Consider the ways borrowing from a 401k will be counted against you when you look to use the money for a home purchase.
Many lenders use the so-called "28/36" rule to determine how much mortgage you can afford. According to this rule, you can afford the lower of either 28 percent of your gross income or 36 percent of your gross income less other debts and obligations. If you have no debt, you will qualify for a higher mortgage than if you have high debts to pay each month. This is important to remember if you consider borrowing from your 401k to make a down payment on the house. The 401k loan is considered a debt and, even though you are repaying yourself, the monthly payment toward this debt will be deducted from how much you can theoretically afford to pay toward a mortgage. The 401k loan is reported on your credit report and your mortgage application, so the lender will have this information when considering your mortgage limit.
Beyond the implications on your mortgage, borrowing from your 401k will also be limited by your employer's regulations. Each plan sponsor can determine if and how much an employee can borrow from a 401k. Some plan sponsors will not permit borrowing at all, but, even after the 2007 mortgage crisis, an estimated 80 percent still permitted borrowing. The borrowing can be capped at low levels, but a 2008 study estimated $50,000 was the average cap. If you use this money for a down payment on your home, you are essentially placing zero percent down, as both the down payment and the mortgages are loans. Therefore, your interest rate may be higher on your mortgage even if the one enforced by your plan sponsor is low.
The Cash Out Alternative
One alternative to taking a 401k loan is to cash out your 401k for a housing down payment. If you do so, you can avoid the standard 10 percent penalty on an early withdrawal. This Internal Revenue Service regulation is permitted only in rare cases, such as first home down payments and hardship withdrawals, and it can offer great financial incentive to cash out of your 401k at a young age. Here, the money is not counted as a loan. Therefore, the mortgage lender would not count this sum as debt in your mortgage application, and you may be able to secure a higher mortgage.
Comparing Loan vs. Cashing Out
While cashing out may result in a higher mortgage and lower interest payments, there is one financial drawback with this option: You may not be able to replace the money in your 401k. Each year, there is an annual maximum on 401k contributions. Once you take this money out, you cannot add it back in if your contributions will be over the annual maximum. Therefore, you could be permanently reducing the funds in your 401k with this option, which will significantly reduce the money you can save and earn for retirement.
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