Using Your 401K to Buy a House – The Pros and Cons

A lot of people saw their 401K balances tumble downhill over the last couple of years. It’s enough to make you sick. It’s also enough to light a fire under you, and that seems to be what’s happening right now for a lot of folks. Many first-time home buyers are starting to use their 401K funds to make a down payment on a house.

Cashing Out for a Down Payment

When my wife and I purchased our first home, back in 2002, the economy was in a serious downturn. It was nothing like the full-scale recession we are seeing today, but it was certainly in decline. She saw her 401K shrink rapidly during this time, and after a while it became clear that the entire balance would soon be wiped out. So we had two choices — cashing out the 401K for a down payment on a house, or trying to weather the storm for a rebound. We chose the first option. We used the money from the 401K (what was left of it, anyway) to buy our first house in Maryland.

Of course, this brings up the question of 401K withdrawal penalties. In our situation, we did not have to pay any early-withdrawal fees because we put the money toward a home. This particular IRA had allowances for first-time home buyers, which is a category we fell into at the time. So if you are seriously considering using 401K money for a down payment on a home, this should be one of your first questions. Will I have to pay a penalty? And if so, how much?

After you research your 401K withdrawal options, and the rules associated with them, you need to do some financial homework and soul searching. Talk to your financial advisor or the person managing your 401K about your plans for cashing out. Get their advice and input. Just realize that it’s your life and your decision in the end.

Buying a House When the Market Bottoms

Let’s assume that you’ve made the decision to use your 401K for a down payment on a house. Now, I’m not saying this is a good idea or a bad one. I will remain neutral. Let’s just assume you’ve decided in favor of cashing out for some home-buying funds. The best scenario I can think of is to buy when the housing market is at or near bottom. In other words, when home values have fallen to their lowest point, signaling and long and steady rise over the coming years.

Guess what? That’s the exact scenario we are seeing in many cities across America right now. In fact, I recently wrote about how home prices are rising in some cities, for the first time in three years. Granted, the “bottom” will vary from one state to another, and even among different cities within the same state. But nobody can deny that the nationwide housing market is at or near bottom right now.

Here’s my point. If you are going to use your 401K to buy a house, it’s best to do it when the market has bottomed out. Why? Because there’s a good chance you will see rising home values for the foreseeable future. In other words, you’ll be getting the best return on your investment — including the part that was funded by your 401K withdrawal.

Arguments Against Using a 401K

Of course, there are plenty of folks who would advise against this sort of thing. And I would be remiss not to include them in my article. So in the interest of balanced reporting, here are some arguments against using a 401K for a down payment on a home.

Jack Guttentag, the self-proclaimed “Mortgage Professor,” points out that the fees and taxes on such a withdrawal can be a real crusher. His advice is to avoid a withdrawal at all costs, or to borrow against the 401K instead.

To which I respond … losing the majority of your 401K due to market decline is also a crusher. Some people do not have the luxury of weathering the storm, because their funds are too small. If I seriously felt my fund was going to disappear, I would cash out for a down payment in a heartbeat. But Jack does bring up some good points. Like I said, you have to find out what cashing out is going to cost you, and then weigh the pros and cons accordingly.