Should I Borrow from my 401k to Fund a Down Payment on my First House?

As home prices have finally regained some level of sanity, many potential homebuyers are feeling the itch to make their first home purchase. Those who don’t have wealthy or generous relatives, significant stockpiles of cash, or liquid assets, are now in the interesting predicament of raising significant funds for a down payment. As nervous lenders are beginning to restrict financing to only those who are able to front the full 20% of the house value as down payment, it has become even more imperative for homebuyers to pony up significant amounts of cash. Should homebuyers consider tapping into their 401ks to fund a down payment on a house? Is it a good idea? Although many may disagree with me, I don’t think so. Here are my reasons:

-If you are fired or leave your current employer through which you have your 401k, the loan is due almost immediately or you run the risk of paying an early distribution penalty.

-Inflation-adjusted home values will most likely not grow as significantly as your investment portfolio. Statistics show that home prices only increased .7% per year from 1940-2004. It is not difficult to imagine your investment portfolio growing at a much more aggressive rate.

-You lose the magic of compounding in your 401k. Over time, small amounts of money can accumulate to significant sums through the work of compounding. If you max out your 401k and IRA for 1 year alone in your early twenties, and assume a reasonable rate of return (let’s say 8-10%), you could easily wind up a millionaire by retirement. By taking out money early in your life to cough up a down payment on a house, you are limiting the power of compounding in your 401k.

-Remember that the 401k loan for a down payment isn’t tax-deductible. While mortgage payments are tax deductible (as long as you don’t exceed a certain level of income), you won’t be able to deduct your down payment. Please also remember that you are using post-tax dollars to pay back pre-tax dollars borrowed from your 401k and that you will be taxed yet once again when you retire and take out funds from your 401k.

So if you don't have the money for a down payment and don't want to draw from your 401k, what options are left? Get an uglier house or wait and save.