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Pay Yourself First and Last – 401k Down Payment

A 401k loan turns an IOU into an "IO-ME"

A 401k loan turns an IOU into an “IO-ME”

Orange County, CA – No matter how excellent your credit, the days of a no-down-payment mortgage in the OC are all but over. Veterans are the only exception. At the same time, rising rates make it an excellent financial idea to lock in your mortgage today rather than wait years to save up for a down payment. Fortunately, many of us have the answer staring us in the face. We can borrow from our 401k accounts to pay our down payments.

When you borrow from a 401k, you pay yourself back, not a bank. You can generally borrow up to half of your balance, up to a maximum of $50k, and you’ve got 5 years to pay yourself back. Some employers will give you up to 15 years if the money is going to finance a home.

Other Advantages

Unlike most kinds of debt, a 401k loan doesn’t count as debt when calculating your debt-to-income ratio, because the loan is ‘secured’ — meaning that if you don’t pay it back, the ‘payment’ is simply deducted from the remainder of your 401k. There’s no danger to the bank, so they don’t count it against you. That means that you can qualify for a larger mortgage (and, ultimately, a better home.) However, many lenders will still factor the repayment into your debt to income ratios. This can limit your purchasing power.

Furthermore, because 401k information isn’t passed to the credit unions, the debt won’t harm your credit score. Even if you miss a payment, your credit score won’t suffer. You can get this kind of loan even if your credit isn’t ideal.

Disadvantages of Borrowing Against Your 401k

That doesn’t mean you shouldn’t pay the loan back. Every payment you fail to make is counted as a taxable early withdrawal from your loan. That means that you’ll first have to pay taxes on the funds you “withdrew”, and then you’ll have to pay a 10% early-withdrawal penalty unless you’re 59-and-a-half or older. If you get fired or quit your job before your loan is paid off, you’ll have either 60 or 90 days to pay off the loan, or the entire outstanding balance will be taxed and you’ll have to pay the early-withdrawal penalty on the whole thing. Ouch!

Similarly, any money you have loaned out isn’t making any interest. So taking a loan on your 401k can put a small dent in your nest egg.

Finally, because you repay the loan with post-tax dollars and you pay taxes again when you take the money out, you’re essentially getting taxed twice on any money you borrow from your 401k.

All Things Considered

Of course, like all things monetary, there are two important considerations about borrowing from your 401k: what can you afford right now, and how much will it cost (or make you) in the long run? The advantage of a 401k is that it’s generally a positive in both scenarios: it allows you to afford more in the short run by tapping unused money and allowing to qualify for a larger mortgage. It also helps you make money in the long run, because while the loan is double-taxed, the amount of money you’ll save by being able to lock in your mortgage interest rate now, while it’s still quite low, will more than make up for the double-down on taxes.

Contact me if you’re looking to maximize your purchasing power.

Scott Storace

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