Can I get a loan from my 401K to use as a down payment towards a home loan?

Technically, YES. Technically, however, doesn’t make something a good idea. Here’s the deal. In my observation, a 401(k) loan is a high-risk proposition. I’ve rarely seen them work out well, to the point that when I advise a client on setting one up I recommend that loans be disallowed. That at least keeps the employer from being an enabler of what generally turns out to be a bad decision.

Humans are particularly bad at assessing “What’s the worst that could happen?” In 2005, a high school class (underage teenagers) from Alabama took a graduation trip to Aruba. What could possibly go wrong with that?? After a night at Carlos’n Charlie’s, one of the girls never came back. While the authorities clearly know the killer’s identity, he’s not been convicted, and even tried to extort $250k from the grieving mother to disclose the location of her remains. Clearly, a failure to assess “What’s the worst that could happen?”

So, what’s the worst that could happen in your proposition? Well, perhaps not the worst case, but surely a bad case would be the spouse owning the 401(k) loses his/her job. At that point, the 401(k) loan is due in full and if that was the only source of cash to do the house deal, I’m guessing you’d have no way of paying that loan back. What that would do is create a 10% early withdrawal penalty on the full amount of the loan, plus state and federal income taxes due the next April on the entire amount of the loan. All in, 40% to 50% of the loan value due to the IRS. And those guys don’t fool around. If you can’t pay the tax bill, they have the right to garnish the wages of the still-employed spouse, thereby putting the house payments in jeopardy, perhaps leading to foreclosure of the house and you can make up the rest of a sad, painful, ugly story. And, that’s not the WORST thing that could happen, particularly if any of a dozen other life crises (serious illness, etc.) befalls the family simultaneously.

See what I mean by how bad humans are at assessing “What’s the worst that could happen?”

Bottom line — There are a TON of unanticipated cash needs of homeownership, some of them 5 figures in magnitude. If this is your first home, you have no idea how those cash needs can stack up. If your financial situation is such that the only way you can do a house deal is by using borrowed 401(k) money, my counsel would be that you’re not yet positioned to make that deal. The downsides are multiple times the upside. Get a second job, squeeze expenses down to nothing and save the down payment plus an emergency fund as fast as possible. You’ll then be going into the house deal with far less risk (more cushion), and you won’t be struggling to stay above water for the next 2, 3, or 4 years thereafter.

Author: Terry Weaver

Source: Quora

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