Using money out of a 401K for a down payment on a home should be weighed against all of the possibilities of providing funding for a down payment. If it ends up being less expensive to do so, then it is a good idea, but if the other options offer a less expensive way to create the down payment, then the home buyer should use those options instead.
A 401K is meant for the person’s retirement. When money is invested in a 401K plan, it is meant to be left there until the person reaches retirement age. There may be substantial taxes and penalties for taking money out of the retirement account before it has matured, and while these are part of the expense that needs to be considered, they are not the only expense.
An often overlooked expense by investors is the opportunity cost of taking money out of a 401K. Along with the taxes and penalties for early withdrawal, there is the loss of earnings on the money after it is withdrawn from the account. This can make a 401K withdrawal very expensive over the life of the account. Withdrawing $1000 from an account that is earning six percent of non-compounded interest can result in the loss of $600 over the course of ten years – that’s 60 percent of the original withdrawal. Most accounts use compounded interest rates, so that number will be even higher, and that is the true cost of taking money out of a retirement account early.
Some employers offer employees the opportunity to borrow money from a 401K for making a down payment. That money is loaned at an interest rate and needs to be paid back within a certain amount time, but the investor shouldn’t let the interest rate on the money fool him or her. That is money that is coming out of the home buyer’s own pocket and not being earned by the account. So there is still the opportunity cost. Beyond that, there is the risk that if the employee losses his or her job or he or she changes employers, that money will need to be paid back within a relatively short amount of time – possible as few as 60 days. In today’s economy, no job is safe. That makes borrowing from a 401K a huge risk. While a 401K can be rolled over into a new employer’s retirement program, a loan from the 401K cannot.
Other options for getting a higher down payment that does not require withdrawals from the 401K may include a second loan and mortgage insurance. When considering this option, home buyers should look at the costs associated with the loan and the percentages associated with both the mortgage insurance and the loan.
Mortgage insurance is usually paid until a homeowner’s equity in the home reaches a certain point. Once that point is reached, the mortgage insurance can be canceled, and that money can be freed up for use in other areas, like applying more money to the principle of the mortgage. Many loan agencies will require this insurance for those who are offering smaller down payments or who are taking out a second mortgage to help finance the home.
Every loan comes with an interest rate. Figuring out what the second mortgage interest rate is and how much it will cost over the life of the loan should take a couple of mathematical equations. If the home buyer is bad at math, the loan officer should be able to help with an analysis of the cost of the loan over its life.
Buying a home is an important investment. It is important for people to get it done right, so they are not trapped with bad debt.