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April 19, 2004
"Is it advisable to use funds
in my 401K as a down payment?"
You don�t want to withdraw
funds from a 401K to make a down payment, but you might want to borrow
from your account. Whether you do or not should depend on whether it costs more
or less than the alternatives, which are to pay for mortgage insurance or for a
second mortgage. Account should also be taken of the risks inherent in these
different options.
As an illustration, you buy a house
for $100,000 and have enough cash to pay only $5,000 down. Lenders will advance
only $80,000 on a first mortgage without mortgage insurance. One source for the
additional $15,000 you need is your 401K account. A second source is your first
mortgage lender, who will add another $15,000 to your first mortgage, provided
you purchase mortgage insurance on the total loan of $95,000. A third option is
to borrow $15,000 on a second mortgage, from the same lender or from a different
lender.
401K:
The general rule is that money in 401K plans stays there until the holder
retires, but the IRS allows "hardship withdrawals". One acceptable
hardship is making a down payment in connection with purchase of your primary
residence. Such a withdrawal is very costly, however. The cost is the earnings
you forgo on the money withdrawn, plus taxes and penalties on the amount
withdrawn, which must be paid in the year of withdrawal. The taxes and penalties
are a crusher, so avoid withdrawals if at all possible.
A far better approach is to borrow
against your account, assuming your employer permits this. You pay interest on
the loan, but the interest goes back into your account, as an offset to the
earnings you forgo. The money you receive is not taxable, so long as you pay it
back.
The cost of borrowing against your
401K is only the earnings foregone. (The interest rate you pay the 401K account
is irrelevant, since that goes from one pocket to another). If your fund has
been earning 6%, for example, that is the cost of the loan to you. You will no
longer be earning 6% on the money you take out as a loan. If you are a long way
from retirement, you can ignore taxes because they are deferred until you
retire.
The major risk in borrowing against
your 401K is that if you lose your job, or change employers, you must pay back
the loan in full within a short period, often 60 days. If you don�t, it is
treated as a withdrawal and subjected to the same taxes and penalties. 401K
accounts can usually be rolled over into 401K accounts at a new employer, or
into an IRA, without triggering tax payments or penalties, but loans from a 401K
cannot be rolled over.
Borrowing from your 401K should not
prevent you from continuing to contribute the maximum amount that can be
shielded from current taxes. If it does, the cost goes out of sight.
Mortgage Insurance:
You can borrow the additional $15,000 you need from the first mortgage lender by
paying for mortgage insurance. The cost of mortgage insurance is roughly 5%
above the after-tax mortgage rate. For example, if your mortgage rate is 5% and
you are in the 35% tax bracket, your after-tax mortgage rate is 5(1-.35) =
3.25%, and the mortgage insurance cost would be about 8.25%. If the mort gage
insurance premium becomes deductible, which could happen soon, the cost would be
10(1 - .35) = 6.50%.
Second mortgage: The
cost of a second mortgage is the interest rate adjusted for taxes. If the rate
is 9% and you are in the 35% tax bracket, the cost is 9(1 -.35) = 5.85%.
While borrowing from a 401K account
involves risk associated with changing jobs, the mortgage insurance and second
mortgage options entail risk associated with changing houses. These options
reduce equity in your house, increasing the possibility that a decline in real
estate prices will leave you with negative equity. This could make it impossible
to pay off the mortgages in the event you want to sell the house and move
somewhere else.
In most cases, however, the risks
involved in reducing your equity in the house are smaller than the risks
associated with borrowing from your 401K. If the costs are close to being the
same, leave your 401K alone.
Copyright Jack Guttentag 2004
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