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By Sky Minor | Broker in Los Angeles, CA
  • Borrowing against 401k for down payment.

    Posted Under: Home Buying in Eagle Rock, Financing in Eagle Rock, Property Q&A in Eagle Rock  |  November 1, 2010 4:04 PM  |  2,624 views  |  No comments
    Borrowing down payment money from 401k?

    Being a fierce advocate of frugality, I caution against anyone tapping into their retirement funds. The only time I can see it making sense would be for a down payment on a home that will be lived in for a long time. If the situation arises and buyers need funds to close escrow and buy their home, it is good to know the available options.

    The cost of using funds in a 401K as down payment should be compared with the cost of mortgage insurance and the cost of a second mortgage, with allowance for the risks associated with each option. The best choice can vary from case to case. Whether you take funds from a 401K to make a down payment should depend on whether it costs more or less than the alternatives, which are to pay for mortgage insurance or for a higher interest second mortgage. Income tax regulations should also be taken of the risks inherent in these different options, because mortgages are most people's biggest tax break.

    As an illustration, you want to buy a house in Eagle Rock for $500,000 but have enough cash to pay only $50,000 down. Lenders will advance only $400,000 on a first mortgage without mortgage insurance (MI). You need to come up with another $50,000 to close escrow. One source for the additional capital you need is your 401K account. A second source is your first mortgage lender, who will add another $50,000 to your first mortgage, provided you purchase mortgage insurance on the total loan of $450,000. A third option is to borrow $50,000 on a second mortgage, from the same lender or from a different lender. 2nd mortgages have become rare after the credit crunch because they are a risky investment for lenders. If you were lucky enough to find a 2nd mortgage in this market, it would be at a double digit interest rate.

    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.

    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 The cost is the earnings you forgo on the money withdrawn, plus taxes and penalties on the amount withdrawn, which must be paid in the year of withdrawal.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 gets high.

    Mortgage Insurance (MI)
    You can borrow the additional $50,000 you need from the first mortgage lender by paying for mortgage insurance. FHA loans, which are the most popular in low down payment situations like this currently charge .8-.99 for monthly mortgage insurance premiums. That is approximately $200 extra per month added to the payment or $2400 per year for MI premiums.

    Mortgage insurance has income tax considerations also. The cost of mortgage insurance is roughly 5% above the after-tax mortgage rate.
    For example, if your mortgage rate is 6% and you are in the 35% tax bracket, your after-tax mortgage rate is 6(1-.35) = 3.90%, and the mortgage insurance cost would be about 8.90%.

    Second Mortgages
    2nd mortgages have become very rare and difficult to find. The interest rates on 2nd mortgages are always higher than 1st mortgages, because in the event of default the 1st mortgage gets paid back before the 2nd mortgage gets a dime. Naturally, in a declining real estate market 2nd mortgages are very tough to come by.

    Seller financing is an option, although the 1st mortgage lender may restrict this. Using seller carry backs is a great way to close escrow, but when dealing with bank-owned foreclosures it is never done.

    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%.

    To 401k or not to 401k?

    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.

    For specific mortgage questions, contact Sky Minor at 310-709-8283 or www.realestatesilverlake.com
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