As a mortgage finance professional with three decades of financial services expertise, I find myself wearing several hats when on the lookout for ways that can help my clients buy a home with less stress and more cost efficiency. One topic that often comes up is using retirement funds as an alternative source for a traditional down payment on a home purchase. As a Chartered Financial Analyst (CFA), tapping into retirement funds – for any use other than intended – always gets my attention! So let’s explore the pros and cons.
A home buyer typically needs to provide 20% of the purchase price in her own funds when getting a “standard” mortgage (there are many other flavors of mortgage, but for now, we’re talking vanilla!) This is called the down payment, and represents her equity stake in the home. To the lender, the 20% equity cushion represents his protection against loss in the case of a default. However, if the borrower has less than 20% for a down payment, she’ll need to borrow more than 80% in her mortgage, which means the lender has less protection against loss in the case of default, and will require mortgage insurance to cover the additional risk.
For example, let’s assume the buyer has only enough funds for a 10% down payment. To avoid paying mortgage insurance, she might borrow 80% as a first mortgage and 10% as a home equity line. This is a common structure called an 80/10/10. Sometimes, however, it may make sense to tap into retirement savings instead of getting a home equity line. An example would be if the buyer’s income is not sufficient to qualify for both the first mortgage and the home equity line. Which brings us to today’s topic:
There are three ways to tap into retirement funds, depending upon how they are invested:
1) Liquidation of an IRA: There are two concerns with this approach: Up to 40% of the proceeds will be withheld by the financial institution (where the IRA is on deposit) to pay taxes and penalties, requiring the buyer to liquidate $16,667 to gain access to $10,000. The 10% penalty for early withdrawal may be waived for the purchase of a primary home (consult a tax professional) but that still would result in a liquidation of $14,286 to gain access to $10,000. In most cases I recommend against this approach, as it may cripple your retirement savings.
2) Withdrawals from a Roth IRA: The beauty of the Roth IRA is that the buyer can withdraw principle contributions (leaving in any earnings) without any tax or penalty as these contributions were made on an after-tax basis. Again, the retirement picture is harmed, but not as severely as in the first scenario as there are no tax implications. To get $10,000 the buyer needs to take out only $10,000 as long at these funds were after-tax contributions.
3) Borrowing from a 401(k): Often, one can borrow up to 50% of the balance in a 401 (k) in the form of a loan, up to a maximum of $50,000. Thus, if the buyer needs $10,000, he must have a balance of $20,000 or more in his 401(k). This is a loan which can be paid back into the fund without penalty, so in essence the money is still in the account, only it is now invested in a loan upon which the borrower pays interest (and which has a 5 year repayment time-frame.) There is no hit to the retirement picture, since the borrower is also the owner of the 401(k), the money is still invested, and growing. And from a loan qualifying basis, the monthly payments to the 401(k) loan do not have to be included in the qualifying ratios of the borrower in getting approved for their mortgage.
Most people will have a mix of IRAs, Roths, and 401(k)s, especially if they have had several jobs during heir career. As always, consult a tax professional before making any early withdrawal or loan from your retirement assets. And when you are ready to start the home buying process, please give me a call, and I can help you figure out the best loan options for you.
