Using a 401k Loan for a Home Down Payment: Pros and Cons

With expenses on the rise and Social Security on the brink of demise, people are beginning to focus more and more on personal retirement savings. Many employers offer 401k plans to their employees, which allow them to set aside up to $15,500 per year, tax-free. Diligent savers can set aside a good chunk of change in a hurry. However, that fat 401k account starts looking very tempting when you're trying to buy a home and are struggling to save that elusive 20% down payment. Here are the pros and cons of resisting that temptation.

A few years ago, most people wouldn't have considered taking a 401k loan to buy a house. Why? Because they didn't need to - lenders didn't care if you had a down payment. Real estate was booming and lending standards had become very lax - 100% financing was widely available, especially to first time buyers. However, since the mortgage industry crash earlier this year, it has become much more difficult to secure financing for a home without a substantial down payment. 20% is common, but that means you need $40,000 in cash to buy a $200,000 home. Saving that kind of money while saving for retirement or other long term goals can be very challenging.

Instead of cutting expenses or putting retirement savings on hold temporarily to save for a down payment, many people are raiding their retirement accounts. It's easy to justify - the money is already there, and depending on your employer's rules, is usually very easy to get. Most 401k loans can be obtained with just a phone call and a little bit of paperwork. The interest rates are usually low (prime plus 1-2%, typically), and you end up paying the interest back to yourself instead of to a bank. You're not taxed or penalized for the loan, as long as it is paid back on schedule.

However, there are some big disadvantages to this as well. First of all, 401k loans have to be paid back immediately (usually within 60 days) if you either quit or lose your job. If the loan isn't paid back, you are taxed and penalized on the outstanding balance. So unless your job is 100% stable, that's an enormous risk. You also lose years and years of compound interest on that money, which can mean tens or even hundreds of thousands of dollars less when you retire. Since you'll be paying back a loan to your 401k, you may also be tempted to contribute less to the plan while you're repaying, which will reduce the size of your account at retirement even further.

In short, the risks involved with taking a 401k loan to buy real estate outweigh any conveniences it may offer. Saving for a down payment the old fashioned way may not be fast, but it's the safest route to home ownership without sacrificing retirement security.