If you’ve spent time as an adult contributing to your retirement account, you may not have a large amount to put down on a home. However, you may be able to use your retirement funds to buy that house.
Is it a good idea, though? Technically, you can do whatever you want with your money. But, there are penalties and taxes to consider. Before you jump in headfirst, consider the following things. Only then can you make the right decision for yourself.
Borrow vs Take
First, let’s clarify the difference between ‘borrowing’ from your retirement funds and ‘taking’ your funds. Taking means you take a withdrawal. You don’t intend to pay the money back. This is considered an early distribution from your retirement account. As a result, there are taxes and penalties that you will owe. Generally, you’ll pay a 10% early withdrawal penalty and taxes on the income.
Borrowing from your retirement account, on the other hand, is just like taking a loan from a bank. If you borrow from a 401K, you’ll need your employer’s approval and will have to follow their rules. They will tell you when the payments need to be made and at what interest rate. They usually take the payments directly from your paycheck too.
If you borrow from an IRA, though, you don’t go through your employer. Instead, you go through the plan administrator. You can borrow up to $10,000 if you are a first-time homebuyer. You will pay taxes on the money you borrow, but you won’t pay an early withdrawal fee.
Benefits of Using Retirement Funds to Buy a House
Borrowing money from yourself does have its benefits. You can:
- Avoid PMI – If you have enough to put 20% down on the home with your retirement funds included, you won’t pay PMI. This insurance usually adds quite a bit to a housing payment, making it harder to afford. Plus, it’s money you’ll never get back and you have to pay it until you owe less than 80% of the home’s value. If you can avoid it, it can save you thousands of dollars in the long run.
- Pay yourself interest – You do have to pay interest on the loan. The good news, however, is that you pay the money back to your own account. You aren’t helping a bank or other entity make a profit.
Disadvantages of Using Retirement Funds to Buy a House
There’s always a downside, no matter how good something seems as is the case with using retirement funds for a home.
- Lose the earnings potential of your investment – You lose the earning power of your money. It’s not just the money you had sitting in the account, but the compound interest you earn by letting the money sit. Even borrowing for a short amount of time can diminish your savings.
- You may not ever catch up – Playing catch up is never easy with a retirement loan. Even though you’ll pay interest, it’s not likely not going to be enough to cover the money you would have made if you allowed the interest to compound.
- You may have to pay loan in full if you leave your job – Most loans are due within 5 years. But, if you leave your employer, the loan may become due and payable immediately.
Alternatives to Using Retirement Money to Buy a House
If you don’t have the money for a down payment, there are a few other options you can use to help you have money.
- Reduce contributions to retirement account – If you have time before you’ll buy a home, you can reduce or eliminate your retirement contributions. If you have a 401K, though, you may want to at least contribute the amount your employer will match. If you can save for a down payment and contribute, you’ll have the ideal situation. If you have to stop contributing, make sure you pick the habit up again after you save for the down payment.
- Obtain money from a relative – Many loan programs including the FHA and conventional loan program allow gift funds. Check with your loan officer to see if your program allows it. If they do, determine the amount you can obtain from a relative. Keep in mind, this can’t be a loan, but rather a ‘gift’ that does not require repayment.
- Put down a lower down payment – If you can’t come up with a large down payment, there are alternative loan programs. The FHA loan requires a minimum of 3.5% down, which is less than the 5% minimum conventional loans require. USDA and VA loans also require no money down. You must buy a home in a rural area and be veteran respectively in order to qualify for these loans, though.
Whether you should use retirement funds to buy a home or not is a personal decision. Explore all of your options. Don’t just assume you should use the retirement money you have sitting around. There are benefits to leaving it alone, such as the compound interest it will make.
If you decide to use your funds, make sure you talk with your loan officer and tax advisor. This way you know all of the consequences you’ll face by taking the loan. Whatever you do, though, don’t take an early withdrawal. The financial consequences will easily negate the benefits of putting down a large down payment.
If you do everything right, you can gain the benefits of using your retirement funds and saving money on your loan in the long run.