The High Cost of Borrowing from Your Retirement to Buy a House
Affordable housing is on the minds of many Millennials, as housing prices outpace inflation and wages. Today, there is an increased pressure to buy a home, before prices increase beyond their reach. The result is more young adults, tapping into savings earmarked for retirement to buy their first home. According to a recent survey by Bank of the West, one third of Millennials surveyed used retirement funds to buy a home, which could cause financial challenges in the future.
One of the biggest obstacles to overcome on the road to homeownership is saving for the down payment and closing costs. With most buyers needing 3% to 20% as a down payment and another 2% to 5% for closing costs, a home purchase requires saving thousands of dollars.
For instance, a $200,000 home with a loan requiring only 3% down, and 2% in closing costs, will still require the buyer to come up with approximately $10,000 to buy the house. If the down payment rises to 5% with 5% in closing costs, the closing requirement doubles to $20,0000. Many buyers struggle to save that much money while managing other debts such as student loans, car payments, and credit card debt.
It can be tempting to raid retirement accounts, to speed up the process. Buyers can choose to make a withdrawal or take out a loan against retirement savings. There are costs and benefits of each option. Here’s what you need to know.
Withdrawing Money from Retirement Accounts
The Advantages of a Withdrawal
No repayment required. You do not have to repay the money, and therefore it doesn't count as debt when qualifying for the home mortgage.
Fast transaction: You can typically receive funds within a week of the request.
The Disadvantages of a Withdrawal
Taxation and penalties: In most cases, taking money from a retirement account before the age of 59 ½ will result in a 10% early withdrawal penalty and could also result in taxation of monies received. The cost will depend on the account you choose to tap.
Loss of retirement account funds: One of the biggest factors in account growth is the time you have until retirement. Taking out funds, which took years to accumulate, can lead to a financial shortfall.
Withdrawal and Taxation Costs by Account
Roth IRAs have the most generous terms as far as access to funds before reaching retirement age. You can withdraw contributions at any time without paying any taxes or penalties. If you have had an active account for at least five years, you can also withdraw up to $10,000 penalty free, provided you use the funds within 120 days of withdrawal to purchase your first home. You can also use the money to buy a home for a spouse, parents, children, or grandchildren, potentially increasing the maximum withdrawal if you combine funds from multiple accounts.
Traditional IRAs also offer a penalty-free withdrawal of funds used to purchase your first home, up to $10,000. Because Traditional IRA funds are not taxed at the time of the contribution, you will have to pay taxes on any amount received. Withdrawals above the $10,000 maximum, with also incur a 10% early withdrawal penalty if you are under 59.5 years old. Traditional IRA funds can also contribute towards a home for spouse, parents, children, or grandchildren.
The $10,000 penalty-free withdrawal for the purchase of your first home, is a lifetime limit on both the Roth and Traditional IRA.
401K or Work Accounts. Unless you have a small business IRA, 401K accounts do not offer withdrawals if you are still working for the company. You can roll over accounts from previous employers into an IRA to gain the withdrawal benefits offered.
Taking a Loan Against Retirement Accounts
Loans are only offered through a current employer, disqualifying IRAs and 401K from previous jobs. There are distinct advantages and disadvantages of taking this route.
Advantages of a 401K Loan
Easy to qualify: A 401K loan does not require approval, a credit check or income verification. IRS rules state you can withdraw the lesser of $50,000 or 50% of the vested balance.
Fast turnaround: In most cases, you can receive the loan within a week of the request.
You pay yourself interest: You are borrowing money from yourself. The interest on the loan is returned to the 401K account as gains.
Avoid taxation: A loan, provided you repay it within five years and remain with your current employer, will not have any tax consequences.
Disadvantages of a 401K loan
Lower borrowing limits: A 401K loan could impact your ability to qualify for the mortgage because you reduce asset balances and increase debt balances. The payment on the 401K loan will count against the debt to income calculation banks use to determine the maximum loan amount.
Limit contributions: Many employers do not allow you to make additional contributions while you have a loan outstanding. You lose the compound growth on the distribution, lose the employer match, and cannot make additional contributions, putting you behind in your retirement savings.
After tax payments: You withdraw pre-tax money and pay back the loan with after-tax dollars, leading to double taxation.
High payments: 401K loans have a maximum five-year repayment, leading to a high monthly bill if you withdraw a large amount. For example, if you borrowed the maximum of $50,000 at 5%, you would have a monthly payment of $943.56.
The Bank of the West survey revealed that 98% of Millennials consider homeownership as an important part of achieving the American Dream. However, buying before you have your finances in order could lead to regret and long-term financial consequences that are difficult to overcome.