Mortgage Insights Blog

RISMEDIA, August 19, 2008-(MCT)-Faced with a real estate market that has tightened up lending standards at a time when home values are dropping, more people are borrowing money from their 401(k) retirement plans to help swing a down payment to buy a home.

But before you think that borrowing from your employer-sponsored 401(k) retirement plan (or a 403(b) if you work for a school or nonprofit) is the ticket to buying a home, this strategy has both pros and cons.

On the plus side, the loan principal, along with the interest on the loan is paid back to you and is lower (currently in the 6.5% range) than what a bank typically charges. Also, there is no credit check required since you are lending yourself the money On the negative side, taking out a loan could significantly reduce the retirement account’s long-term growth and earning potential, especially if you stop making contributions while paying off the loan. (That is if you can. Not all plans allow you to make contributions while your loan is active). There is also a tax hit if the loan is not repaid.

Whether you can actually borrow from a 401(k) is up to the plan sponsor, which is your employer. About half of the plans sponsored by the nation’s employers (which collectively reach about 85% of the nation’s 47.2 million 401(k) account holders) allow loans, according to industry statistics. Borrowing is typically capped at $50,000, or up to half of the vested amount, but requires a minimum loan amount of $10,000.

But just ask a financial consultant, like Jim Titus, a vice president in the San Francisco headquarters of financial services firm Charles Schwab & Co, and you might get a very negative response, “number one is the opportunity costs of borrowing - you end up losing the (tax-deferred growth potential) when you take the money out of your 401(k) and the interest you pay back (on the loan) is unlikely to earn as much of a return as your 401(k) investment.”

That said, there are reasons to consider borrowing from a retirement plan to take advantage of the steep drop in home prices in the wake of the mortgage meltdown sparked by the sub-prime loan crisis that began last year. The meltdown has also made lenders reluctant to provide no-money down loans or piggyback lending, which amounts to two mortgages packaged together to finance a home purchase.

“There are some clear risks of using a 401(k) as a funding source for a down payment on a house. You have to assess those risks and weigh them against the particular economic opportunity you have to buy a home. Under normal circumstances, I think borrowing from a

401(k) to purchase a home is ill-advised. But because of what’s going on in the real estate market, special and exceptional opportunities do arise,” he said. “There are some tremendous values… Right now, real estate in a depressed market, I think it’s a great investment.”

But, while a 401(k) loan can indeed help provide the down payment on a home, keep in mind that lenders typically treat the money as a form of debt. That could have an impact on your qualifying “debt-to-income ratio” (a ratio that analyzes your income versus your debt obligations) for the size of the home loan for which you can qualify. The flip side is that using 401(k) money for a down payment could provide the needed equity to avoid paying mortgage insurance which can also help offset any debt obligations incurred from borrowing from your 401(k). And mortgage insurance is not always tax deductible.

Retirement fund loans have to be repaid within five years. But there is no set time frame for paying back the loans if they are used to make a down payment on a primary home. The loans are not subject to ordinary income taxes associated with withdrawals as long as the full amount is repaid. If the loan is not repaid, it is a treated as a distribution subject to ordinary income taxes. A 10% early withdrawal also applies if the account holder is under 59 ½ years.

Given that the stock market has been sliding in recent months, it might be tempting that the interest rate you would pay to yourself on a 401(k) loan could provide a better return than the retirement fund is currently earning. But although in the short term, the interest may currently be outperforming the stock market, it is very unlikely that the interest is going to outperform the stock market in the long-term over the length of the 401(k) investment.

The loan is also being repaid with post-tax dollars, not the pre-tax dollars used to fund the retirement fund. So if you are in the 28% tax bracket, you are actually paying back $1,280 for every $1,000 borrowed on top of the loan interest, he said. Also, the interest paid on the loan is not tax-deductible.

There are other things to be aware of if you are considering taking out a loan. If an employee ends up losing his or her job, most loans have to be paid back within 60 to 90 days. If the loan is not repaid by that time, then the unpaid loan balance is treated as a distribution subject to income taxes and a possible early withdrawal penalty.

Also, check your 401(k) plan as it may not be possible to make contributions while the loan is active. And even in cases where they do, it may be difficult to make both a loan payment and contribution. Additionally, by not making contributions while the loan is active, you also stand to lose out on the potential for employer contributions.

Wondering how taking out a 401(k) loan could impact your retirement nest egg? Find out the answer by visiting an online calculator at c.standardandpoors.com/calculators. Choose the “Borrowing From a 401(k) Calculator” link.