Using 401(k) loan funds may be appealing to homebuyers who need to access some cash quickly to use as a down payment or to pay for other costs associated with procuring real estate. However, before tapping into your retirement savings, you should know about what may be the benefits, risks, and overall financial consequences involved in doing so. Here's what you should know about a 401(k) loan: what it is, when it may be a good idea and some risks you should watch out for.
What is a 401(k) Loan?
A 401(k) loan lets you borrow some money from your retirement account, thus making no distribution so that you would pay taxes or penalties for early distribution. Unlike permanent distribution, which is taxed and can incur penalties depending on your age, an effective 401(k) loan is nontaxable-at least if it is paid within the allowed timeframe. In a nutshell, you are borrowing from yourself, expecting that funds will be replenished.
Why They Turn to a 401(k) Loan for Real Estate
Normally, homebuyers will choose to tap the 401(k) account for certain reasons; among them include;
Avoid High-Interest Loans: Many homebuyers fear taking an expensive personal loan or a high-interest bridge loan; hence, they will reach into their 401(k) to fetch quick cash.
Meeting Down Payment Requirements: For some first-time homebuyers, barely missing the mark to make a 20% down payment, a 401(k) loan gives them just enough to push them over the threshold so they might avoid paying for private mortgage insurance or may even qualify for better mortgage rates.
Bridging the short-term liquidity gaps by taking a 401(k) loan. A 401(k) loan allows one to bridge between a home purchase and selling another property. The monies are paid back when selling the original home.
What is a 401(k) loan and how does it work?
401(k) loan: you're borrowing from your own money in retirement. Because it's sort of loaning it to yourself, there is usually no credit check involved with the 401(k) loan process. Typically, you can borrow up to 50% of your vested account balance, or $50,000, whichever is less.
Then you have up to five years to pay back the loan, with interest. That makes things a bit odd-understandably so when you think about the fact that you're just paying interest to yourself, but remember also that the sum you borrowed is no longer an investment; while that period lapses, you're sacrificing some market gains, so watch out for that.
Important Things to Know Before Borrowing from Your 401(k)
A 401(k) loan can prove to be helpful in financing the cost of purchasing a home, but borrowing from this means involves potential risks and disadvantages:
You will face penalty and tax risk: One of the major risks involved in borrowing money through your 401(k) is that you may end up paying penalties and taxes if the loan is not paid on time. In case you are unable to repay the loan according to the terms, then the IRS will consider the loan as a distribution. Therefore, you pay income tax on the full amount and another 10% early withdrawal penalty in case you are under age of 55.
Lowered Retirement Savings: When you take some money out of or borrow some money from your 401(k), that money does not go to investments. As much as you are repaying the entire amount with interest, this will be the same amount not earning any money for your retirement account in the duration of the loan. Over time, this would get you out of your retirement savings, especially when the stocks appreciate while your money has moved out of the account.
Employer-Specific Restrictions: Check plan provisions on your employer's plan. Some 401(k) plans allow you to borrow, but there may be restrictions: perhaps how many loans you can take as you want, how long you can carry them, or maybe repayment terms. If you leave employment, the loan could come due in full immediately upon leaving.
Effect on Your Debt-to-Income Ratio: The amount of house you can afford will be determined by the lenders based upon your debt-to-income (DTI) ratio when you are borrowing mortgage money. Some mortgage programs will not count a 401(k) loan payment when determining your DTI ratio, but call your lender to find out how that might affect how much you can borrow with the loan.
How Lenders View 401(k) Loans
Even when assessing a homebuyer's credit history, lenders have different ways to view a 401(k) loan. Typically, lenders do not consider a 401(k) loan to be a "traditional" debt-it will not normally affect your debt-to-income ratio. That varies with the lender and loan program, though.
Some of the above home loan options give you the flexibility to withdraw the balance in your 401(k) as reserves, which can even make the mortgage option more feasible. Generally, however, the lenders do not opt for this full balance but take a percentage of it-usually between 60 and 70 percent there is always a possibility that some fees will be applied or a downward trend may come in for the value of your account.
When Would It Be Best to Withdraw Cash for a 401(k) Loan for Real Estate?
But there are situations in which a loan of your 401(k) to support buying a home is justified, such as:
Short-term cash flow needs: You might have a short-term need to use the cash to close on the property and be confident that you will be paying it off shortly thereafter-hoping to repay with cash generated through selling another property-but a 401(k) loan ensures that the money to buy or close on a home can be borrowed without taking on a high-interest loan.
Try to avoid the weight of Private Mortgage Insurance (PMI): If your 401(k) loan does allow you the possibility of making a 20% down payment, then you might avoid PMI and therefore save some amount. Savings may quite go a long way and be more than the lost investment returns within your 401(k) in the long term.
Lower chance of stock market volatility: If the stock market is likely to melt down, you might be more likely to borrow from your 401(k), depending on how soon that loan will be repaid.
When Not to Borrow from Your 401(k) on Real Estate
Sometimes it would really make good sense to invest some of your retirement savings in real estate, but other times it just won't work. Here are some scenarios where you probably don't want to withdraw your retirement savings to invest in real estate:
Long Repayment Period: If you cannot repay in a few years, the loss of growth in your investment will cause serious damage to your retirement savings.
Unstable Job Situation: A situation where you will have to keep changing your jobs or even get laid off from work. You might have to repay this loan in full in a hurry to avoid penalties of withdrawal in advance.
Conclusion
There are risks in using a 401(k) loan to finance under some circumstances. You need to balance the convenience of having ready cash against the long-term cost of accessing your retirement funds. You should consult your financial advisor and mortgage lender to understand whether or not it makes sense to take out a 401k loan based on your overall financial plan.
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