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A variety of factors at play in the current US economic landscape, from rising inflation to significant student loan debt, have made it difficult for first-time home buyers to save for a down payment. One solution is to take money from a 401(k) account, a process typically referred to as a 401(k) loan. But leveraging a 401(k) loan for a down payment has its downsides.
“Pulling money from your retirement plan can seem like an easy decision when you have an opportunity to buy your dream house,” says Lance Morgan, Founder of College Funding Secrets. “But it can have a big impact on your finances, both in the near future and farther down the road. While there are situations where it makes sense, most of the time it ends up hurting your earning potential while exposing you to tax risks.”
Morgan is a best-selling author and Certified Financial Educator who specializes in helping high-net-worth families use tax and real estate strategies to significantly reduce the cost of college without jeopardizing their retirement savings. Through College Funding Secrets, Morgan shares actionable strategies in plain English that help families navigate the complex intersection of tax planning, financial aid, and real estate investing. His Creative College Funding System is a done-with-you program that has already saved real families millions on tuition bills.
The downside of taking a loan or withdrawing from your retirement account
A 401(k) loan essentially involves borrowing money from yourself, with the principal and interest you pay on the loan typically deducted directly from your paycheck. The rules that govern the transactions limit the amount of the loan to the lesser of $50,000 or 50% of your vested account balance and require the borrower to repay the loan amount within five years.
Taking a 401(k) loan doesn’t require a credit check, making it easier than securing a personal loan from a bank. However, a 401(k) loan can derail retirement savings, even when it is paid back properly.
“The most important thing to consider when taking a loan against your 401(k) is that you are interrupting compounding interest by reducing the size of your retirement savings,” Morgan points out. “Your employer isn’t giving you money out of their pocket. You are simply accessing your 401(k) money without suffering the penalties typically associated with an early withdrawal.”
Morgan also warns about complications that can arise with 401(k) loans if the employee leaves the company before repaying the loan in full. In such cases, the unpaid loan can trigger penalties and additional tax exposure.
“If you leave your place of employment before you repay your loan, the money taken from the retirement account is considered a withdrawal,” Morgan explains. “If you aren’t 59 ½ at that point, then you face a 10% early withdrawal penalty on top of being required to pay income taxes on the money. It’s definitely a risk you need to consider.”
When borrowing from your retirement savings is a smart move
Morgan classifies buying a house to live in as a lifestyle purchase, which he says is not a great investment. Consequently, pulling money from your retirement fund to cover the purchase is never a wise financial decision. However, Morgan sees the value in drawing on 401(k) savings for certain real estate purchases.
“It makes sense to borrow money when you have the potential for a return from the purchase that is greater than the interest,” Morgan says. “In that case, you are gaining leverage and not debt. Buying an investment property — not just a house to live in — is that type of purchase.”
A rental property that generates a reliable cash flow is one example of the type of purchase Morgan describes. Using money from a 401(k) for a down payment on that type of property can lead to a significant return.
“If you can increase rent over the years, the cash flow from your investment property could grow to $40k a year net by retirement age,” Morgan says. “That would be the equivalent of having a million dollars in a 401(k) and drawing 4%. Plus, the income could continue to increase during your retirement years while the house continues to appreciate.”
Weighing the costs of 401(k) loans and withdrawals
When weighing the costs of a 401(k) loan, homebuyers often focus on factors such as interest rates and the loan repayment period to assess the financial implications. But to understand the impact, they need to assess the opportunity costs.
“When you tie up money in a lifestyle purchase like a house, you lose the opportunity to invest that money in something that could generate income,” Morgan says. “When you use a 401(k) loan to fund the purchase, the opportunity costs increase because you are also losing the ROI you gain from compounding interest. If your goal is minimizing your opportunity costs and maximizing your return on investment, you won’t use a 401(k) loan as a down payment.”
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