If you’ve been house hunting lately, you know that the market is a tough one for buyers. Prices are through the roof, interest rates are the highest they’ve been in years, and inventory is low.
If you do find a house you love and manage to put in an offer before someone else snatches it up, it can still be tough finding the money for a down payment. So some people are turning to borrowing from their 401(k)s to help with this.
A larger down payment can help you get a better interest rate on your mortgage. But is pulling from your retirement fund the best way to do this?
Turns out, it isn’t.
We’ll explain what happens to those borrowing from a 401(k) for a house down payment and give you some better alternatives, including one that lets you access the money you’ve already earned without having to shoulder a tax burden for it or incur expensive penalties.
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What Is a 401(k) and How Does It Work?
A 401(k) is an earmarked savings account offered by many businesses to help employees save for retirement. The IRS defines it as a profit-sharing plan and allows people to put a portion of their wages into an individual account tax-free.
Employers may also contribute to these accounts, and many businesses have a matching plan where they will add an equal amount to what the employee puts in up to a certain percentage or dollar value.
Though a 401(k) comes with tax benefits and provides a secure savings plan, one trade-off is that your access to this account is strictly limited.
Can I Take Money From My 401(k) To Buy a House Without Penalty?
Under most 401(k) plans, distribution begins when you turn 65, which is considered to be retirement age. If you take out money before the age of 59½, there will usually be an income tax equal to 10% of the withdrawal amount and you may incur additional fees.
So while you can take out money from your 401(k) to help with a home purchase, it is not without penalties and is not only disruptive to your retirement savings, but can also end up being a more expensive funding source than other alternatives.
In certain situations, borrowing from your 401(k) for a house may qualify as a hardship distribution. This means you don’t have to pay the money back to your account, but you’ll still be taxed on it. Plus, this will leave your retirement account with fewer interest-earning funds than you had before.
Is It a Good Idea To Borrow Money From Your 401(k) for a House?
If you want to borrow money from your 401(k) for a house down payment, you may need to reconsider. Not only will you incur the 10% early withdrawal penalty, but you’ll also pay for it in the long run with reduced savings. So this isn’t a good idea or the smartest way to get the extra money you need.
Instead, why don’t you get a cash advance on your PTO from Sorbet?
We’ll explain more about how this works later, but it essentially allows you to unlock compensation that you’ve already earned. Instead of turning to high-interest loans and predatory lending options, Sorbet helps you access an untapped source of money you already worked so hard for.
2 Disadvantages To Borrowing From a 401(k) for a House Down Payment
We’ve already said that taking money from your 401(k) early isn’t the best idea. Let’s really dive into the specifics so you can see exactly what you’re getting into if you go this route.
#1: You’re Stealing From Your Future Self
Taking an early withdrawal from your 401(k) account is basically like taking out a loan against yourself, or you could even say it’s like stealing from the older you. If you plan to pay the loan back, you’ll also have to pay interest. And the time you spend paying it back could have been spent on growth instead if you never removed that money.
Let’s look at a specific example. Say you have $20,000 in your 401(k) account, but you take out $10,000 to help with the down payment on a new home. If you have a 7% annualized return, the $10,000 that remains will grow to almost $55,000 over 25 years.
But if you don’t touch that money and leave the entire $20,000 to accrue interest, the same return rate would give you almost $110,000 in the same amount of time. So to borrow just $10,000, you’ll end up costing yourself almost $55,000.
Borrowing from your future self could mean that you’ll retire with less money or that you’ll have to put off retirement and work longer. Don’t waste all your hard work by borrowing from your 401(k) and affecting your retirement plan! You may think you really need the money now, but you’ll probably regret that decision in the future when it’s time to start drawing on your funds.
#2: It’s a Tax Burden
Paying regular yearly taxes on your income is enough of a hassle. Add to that an extra 10% tax on the money you’ve borrowed from your 401(k), and you’ve created quite a burden for yourself that can be very difficult to crawl out from under.
Not to mention the fact that the extra taxes you’ll incur will make it hard to find the funds to pay back the money you borrowed from the account in the first place.
3 Alternatives To Borrowing From a 401(k) for a House Down Payment
We hope we’ve convinced you that borrowing from a 401(k) for a house is not a good idea. So what can you do instead?
Here are a few alternatives to that path.
#1: Loan
The whole point of making a bigger down payment on a home is to lower your mortgage and get a better interest rate. So if you borrow money just for the down payment, this kind of defeats the purpose.
But the following types of loans may work in your favor if you’re able to use them for the entire home purchase amount.
FHA Loan
An FHA loan is government-backed by the Federal Housing Administration. It has looser requirements than most loans — such as lower credit score requirements and low down-payment options — and makes it easier for first-time homeowners to buy a property.
FHA loans require a minimum down payment amount of 3.5% for people with a credit score of 580 or higher and 10% for those with lower scores. They also require mortgage insurance for the life of the loan (or 11 years if you put down at least 10%), which includes an upfront charge and an annual premium.
So while these terms might be better than with other types of loans, the costs still add up.
VA Loan
A VA loan is government-backed by the Department of Veterans Affairs. These loans also offer lower interest rates and more flexible terms, but they do not require a down payment.
VA loans are only offered to those who:
Served 90 days of consecutive active service in the military during wartime
Served over 180 days of active duty during peacetime
Served over 6 years with the National Guard or Reserves (or at least 90 days under Title 32)
Are veterans discharged for disability reasons; or
Are the spouse of a military member who lost their life in the line of duty or from an injury sustained during active service
VA loans generally have better terms than FHA loans, but not as many people are eligible for them.
#2: IRA
If you have an IRA, it will probably be cheaper for you to borrow from that than from your 401(k). That’s because they have special provisions for first-time home buyers (which the IRS considers anyone who hasn’t owned a primary residence in the past two years).
These provisions allow qualified buyers to withdraw up to $10,000 from the retirement account without the 10% penalty, although you still will have to pay state and federal income taxes on the amount. If you take out more than $10,000, the 10% penalty applies to the additional funds.
#3: Sorbet
What if we told you that there’s another option that allows you to get the money you’ve already earned without affecting your future retirement funds?
That option is Sorbet.
Instead of taking out a loan or getting an advance on your paycheck — or even worse, stealing from your future self — Sorbet allows you to advance out your unused PTO. You’re gaining access to money you already earned without incurring high fees and penalties.
How Sorbet Can Help You Put a Down Payment on a House
So how does it work?
With most jobs, you accrue paid time off for each period you work. You can take this as vacation time (there's plenty of reasons why you should use your vacation days) and even use your PTO after giving notice. But the majority of people end up earning a lot more days than they actually use.
Many companies offer an option for you to “cash out” these days by exchanging them for the pay rate you receive at the time of your departure or retirement. Sorbet allows you to access this money at any time without waiting until you are no longer with the company.
For example, let’s say you have $1000 in locked PTO funds right now. Sorbet will advance that to you now instead of having to wait until you leave the company to get it.
Then every month, you’ll pay Sorbet a very small percentage of interest on the advance. When you leave your job and cash out your PTO, you’ll repay the $1000 to Sorbet. Or, if your employer has a relationship with us and offers our services through the business, they would pay us directly.
It’s such a simple and low-cost way to get the money you need for a down payment on a house, a special trip you want to take, or anything else you need.
So why not buy a house and protect your 401(k) with Sorbet? Contact us today and see how a PTO advance can work for you.
Read more about what credit card cash advance is and how to get it.