For many prospective home buyers, getting funds for a down payment and closing costs can sometimes be a difficult task. In fact, most people would say that their biggest barrier to purchasing a home is the ability to bring tens of thousands of dollars to the table.
This can lead to buyers accessing a retirement account as a way to provide funds for buying and While this is allowed, there are some factors and drawbacks that you might want to consider.
The case for using your 401(k)
Even if you’re fine with the 10% early withdrawal penalty, you’ll still be paying a price in the long run by decreasing your savings. Likewise, you may decide that you are better off waiting to buy a home next year but this can also put you in a worse position as the prices of homes normally increase year over year. From 2020 to 2021, the average price of a home in the country appreciated at a whopping 21%!
You don’t necessarily have to liquidate your 401k but instead, you can take out a loan against it. This essentially the same as taking a loan against yourself which you can pay it back, with interest. By taking a loan against your 401k, you avoid paying the 10% early withdrawal tax penalty as well the money you draw is not subject to income tax.
In addition, a 401k loan does not count against your debt-to-income ratio and it’s also not an added debt that goes toward your credit profile. This means it won’t decrease your scores and won’t affect your odds of qualifying as well.
So, can you use your 401k to buy a home?
The answer is yes, but there are a couple of caveats.
First, you need to know that if you withdraw money from your 401k early, you will pay a penalty and the amount of the penalty depends on several factors such as how old you are and how old your employer is
Withdrawing money from a 401k
The alternative to taking a loan against your 401(k) is to take a direct withdrawal from your account. This is not the best solution and this is why:
Early withdrawals are classified as hardship withdrawals. The IRS considers any emergency removal of funds from a 401(k) to cover “an immediate and heavy financial need” as a hardship withdrawal. Normally, the purchase of a home using your 401(k) does not count as a hardship withdrawal and you will likely incur the 10% early withdrawal penalty.
However, sometimes there are exemptions in place for specific circumstances, including home buying expenses for a principal residence or if this is your first time buying a home. Speak with your 401k manager in order to get the best idea about your personal situation.
Other alternatives to using a 401(k)
Family gift
It is totally admissible and legal for a family member such as parents or other relatives to give you the money for the purchase of a home. This is what is called a gift and it does not count against your debt to income ratio.
Sell items to raise funds
You can save up funds by selling items that you don’t need anymore. Use the money to put towards your home purchase and this will not affect your debt-to-income ratio at all. Make sure that you keep receipts and bills of sale especially if you sell a large ticket item such as an expensive electronic or a vehicle.
You can also sell items you have around the house in order to get funds for buying a home. These are called your “personal assets” and they will not affect your debt-to-income ratio either.
Maximize IRA contributions
If you have an IRA account, it is possible to withdraw up to $10,000 without being subject to the early withdrawal penalty. This is assuming that you have not reached age 59½ yet and this can be a great way to get funds for buying a home. However, that $10,000 is still subject to state and federal income taxes. If your withdrawal exceeds $10,000, then the 10% penalty is applied to the additional distribution.
Consider a low down payment program instead
If you really want to buy a house but don’t have enough funds for the down payment, then consider applying for an FHA loan or a low down payment conventional mortgage.
The minimum credit score requirement for FHA is 580 and they allow for 3.5% down payment. At the same time, conventional loans only require a 3% down payment if you have great credit scores and a low debt to income ratio.
There are a lot of options but the wisest step you can take is to first consult with a mortgage consultant before anything else. At Andes Mortgage LLC., we set up a personalized consultation to help you navigate the loan process and formulate a strategy for your home loan. Get started with one of our experts today.
