Real Estate Madness and Borrowing from Your 401k

With the real estate market as tight as ever in some locations, many employees may be getting advice regarding loans from their 401ks. While that might be appropriate for some buyers in some circumstances, it’s not a one size fits all scenario. Instead, it could be important to explain how individualized this decision can be.

The housing market is notoriously tight in some regions of the country like the Pacific Northwest and sunny San Diego. Some news sources even report bidding wars over condemned properties in those areas.  But other areas of the country, like the mid-Atlantic region, have tight inventory as well.  In fact, the National Association of Realtors reported that February 2017 had one of the lowest levels of inventory on record.

First time buyers are hit the hardest by the low inventory of housing. According to a report from Trulia, those buyers have to spend a greater proportion of their income on buying a house in the entry level market compared to those looking to move to gain more space. Trulia’s report estimated that first time buyers would have to spend 38.8% of their income on housing, versus a more modest amount for the upgrading group. The amount needed from their income, coupled with the low inventory could put pressure on those buyers to dip into their retirement accounts.

Or, it could be a generational issue. LearnVest and Ameriprise Financial report that 17% of Millennials have taken a loan from their 401K programs. That amount is somewhat higher than the 13.1% for GenXers and 10% for Baby Boomers.

Withdrawing money from a 401K early has its own heartbreaks including penalties and fees. And, not all of the amount in the 401k can be used for a down payment. While some blogs on personal finance urge readers to take loans from their 401ks, rather than cashing out the securities or bonds in them, those loans may need to have careful structuring.

If a tight housing market pushes a family to purchase a home slightly beyond their means, entering into a loan with an equally tight structure might not be flexible enough to account for changes in the employment market or the need to access additional education (or certifications) to keep relevant in an particular labor area. Health care and sudden unexpected housing repair costs not covered by a homeowner’s insurance policy might also tip the dream home into a debt nightmare. Failure to make a payment on a 401k loan for 90 days flips that loan into a distribution, and can incur tax penalties. Failure to make a payment will incur income taxes on the balance of the loan. Most likely, if a payment can’t be made back to the 401k because of an employee being short funds over a period of time, they certainly can’t afford the income tax hit for the additional amount of the balance. Worse yet, if you are let go from your job, you must repay the loan in its entirety within 60 days.

That means understanding an employee’s (and their significant other’s) health and job status is critical. Understanding the length of their loan and the stability of their job position, especially for those with jobs in markets that have their own shrinking inventory of replacement positions, like law, will be a necessary piece of information an employee should consider.

It’s also crucial to know which of an employee’s retirement accounts are eligible for a loan. All but about 13% of the 401ks in this country allow for loans, but IRAs do not (though IRAs do allow for loans for health emergencies and tuition in certain circumstances). That might mean if an employee has a mix of retirement products, a loan from a 401k might have less impact.

401k rules usually only allow for a loan of up to $50,000 that must be repaid in five years, unless it is being used as a down payment on a home. Additionally, interest payments on the loan from a 401k aren’t tax deductible.  In contrast, interest payments on a home equity loan are tax deductible.

It’s also worth considering that very often one loan from a 401k turns into another. A recent survey by Fidelity found that once you dip into your 401k, you are likely to go back for a second, double-dip.

Other questions to consider for the employee would include the amount of the loan and whether emergency funds existed to fill in payments if an emergency arose, other debt spending habits (such as running up and paying off credit card debt with consolidated loans), and if the loan is intended to cover the entire down payment or merely supplement an amount previously saved.

Obviously, thought should be given to how quickly an employee might be gaining family members (either children or aging parents) and how that might impact the length of time the employee would want to hold the home (as to whether the employee wants to choose a 5 year payback option versus something longer like 10 or 15 years).

In any scenario, the idea that borrowing from your 401k to purchase a home is an easy way to pay for a down payment on real estate should be met with caution. There are too many variables for an employee to not proceed with caution.