Don't Raid Your 401(k)
To Fund a Down Payment
July 06, 2004 -- A warning to those of you thinking of tapping your retirement savings to fund the down payment on a new home:
"Don't do it," says James J. Holtzman, a certified financial planner at Pittsburgh's Legend Financial Advisors Inc. "You end up giving away a big chunk of your savings to income taxes and penalties, and you forever give up the tax-deferred growth on earnings and contributions. You're basically throwing money away."
He's right. Yet first-time home buyers, like Paul and Rose Johnson of Bakersfield, Calif., often make the mistake of using their retirement accounts and 401(k) savings to finance a down payment.
The Johnsons thought they had it all figured out. After changing jobs, Paul had planned to rollover the $36,000 balance from his former employer's 401(k) plan into an IRA. But a desire to live closer to their parents and worries that mortgage rates would head higher spurred them to cash out the 401(k) account last year and use some of the money to buy a home. But they were in for a rude awakening -- one that would have a long-lasting impact on their finances.
"We've never really struggled to make the payments on our home, but you could say we're struggling to live," he says. "We're making more money, but a lot of that is going into improvements on the home." The couple also still owes state and federal taxes on the retirement-account withdrawal, and they haven't started to rebuild their nest egg.
While real estate has proved to be a solid investment over time, spending down your retirement savings to purchase a home can have a negative long-term effect on your financial health. In this week's Fiscally Fit, I look at the consequences of using retirement savings for home purchases and suggest some alternatives for would-be home buyers.
The Financial Whack
Young home buyers, like 32-year-old Mr. Johnson, may consider the decision to use retirement cash for a down payment on a home as trading one long-term investment for another.
"For two years prior to cashing out, I was losing money in my 401(k)," he says. The couple felt investing the money in a home was a better bet.
But there are many adverse side effects to liquidating a retirement-savings plan: In addition to paying income taxes and the early withdrawal penalty (generally, 10% of the account balance if you're 59 ½ or younger), you lose future tax-deferred earnings and compounding on the savings.
The dent to your finances in retirement can be enormous. To see how your retirement savings could grow if you leave your savings untouched until retirement, use this 401(k) calculator, provided by employee-benefits consulting firm BenefitPlansPlus LLC in St. Louis.
A loan from your 401(k) may seem like an attractive option -- particularly if you've built up a significant sum and the prospects for future employment seem bright. With a retirement-plan loan, you borrow a chunk of your savings tax-free, and then repay the outstanding balance with interest (usually 1% to 2% over the prime interest rate) to yourself over a period of time (generally five to 10 years).
A great deal, yes, but even 401(k) loans have a financial cost.
In addition to upfront and ongoing administration fees some plan administrators charge on account loans, the money you pay yourself back comes from after-tax earnings, which doesn't lower your annual taxable income the way regular 401(k) contributions do. Also, you may be cashing out investments in your retirement account at a time when the stock market hasn't fully recovered -- selling low generally is a bad idea. And, as with an account withdrawal, you lose out on the time that chunk of savings could have been growing tax deferred. Finally, if you lose your job and can't afford to pay back the loan, you'll owe the same taxes and penalties as you would have if you have simply cashed out the loan balance.
Things to Consider Before You Crack
While emptying your retirement account may be the fastest route to home ownership, it's not the only one. Here are a few alternatives to consider before you crack that nest egg.
Wait. The down payment may be the least of your financial worries. Most first-time home buyers don't consider the myriad costs that come with home ownership, including routine maintenance, property taxes and private mortgage insurance (if your down payment is less than 20%), says Mr. Holtzman, the financial planner.
If, in addition to a monthly mortgage, you're also carrying student or car loans, or even wedding debt, "it may make sense to continue to rent for a few years, pay down those other debts and save up some more to make the minimum down payment required," he says.
Downsize your desires. If you can't afford a $25,000 down payment for a home without completely tapping out your savings, you probably can't afford a $250,000 home. While a cozy three-bedroom in the 'burbs sounds like the perfect solution for your family's cramped housing conditions, you may have to settle for a less-expensive "starter" starter home, at least for now, says Mari McQueen, associate editor of financial-planning newsletter Consumer Reports Money Adviser, Yonkers, N.Y.
"Before you even begin to think about the size of the down payment, it's important to consider what you can really afford, and for some that's a lot less than they think," she says.
Consider a piggyback loan. To avoid the down-payment pinch, it may make sense for high-earning borrowers with good credit to consider a so-called 80/20 loan. With an 80/20, a borrower is loaned 80% of the home price as a traditional mortgage, along with a second loan to cover the 20% down payment. In effect, you borrow 100% of the home price and by doing so you avoid having to pay private mortgage insurance.
Mortgage rates charged on these types of loans run higher than regular fixed-rate mortgages, particularly on the second loan.
"The interest rate charged is usually 1% or 2% percentage points higher than a traditional loan, but the interest is deductible given the right circumstances," says Mr. Holtzman. That rate would be significantly higher, however, if your credit history has more than a few dents.
Now, let me be clear: Borrowing 100% of the cost of your mortgage is a very bad idea if your current finances or job is on shaky ground, or if your poor credit history will result in a sharply higher-than-average mortgage rate. Under these circumstances, it would be prudent to rent for a few years, clean up your credit record and save for the down payment on your own.
Have a plan to rebuild the account. If after considering all the alternatives you do decide to raid your retirement savings, make sure that you incorporate future account contributions into your budget after the home is purchased, says Brett Berg, director of advanced sales at Nationwide Financial Services Inc., in Columbus, Ohio.
"Borrowing from a retirement account can be attractive for some situations as long as [account owners] realize that in addition to paying back the loan they need to continue to defer savings," he says. "Unfortunately, while paying those loans back some individuals stop making their regular contributions."
At the very minimum, you should set aside enough of your earnings in your retirement account to cover any employer match your company may offer, and set a goal to return to your pre-loan contributing level (the recommended rule of thumb is 10% of your annual salary) before the loan is paid in full.
Email your comments to rjeditor@dowjones.com.