What to Know Before Using a 401(k) Loan for a Down Payment

If you're struggling to save enough for a home down payment, a 401(k) loan might look like a quick and easy solution, especially if you have more money stashed in that account than anywhere else.

Among Americans with retirement accounts, including 401(k)s, the median account value was $65,000, according to the Federal Reserve's Survey of Consumer Finances, based on the most recently available 2019 data. The median value of transaction accounts, such as savings, checking and money market accounts, was $5,300.

Many employer plans allow 401(k) loans, and the upsides can be attractive: Essentially, you're borrowing from and paying interest to yourself. The loan generally doesn't count as debt when lenders calculate your debt-to-income ratio.

But borrowing from retirement savings has downsides, and some financial planners advise against it, period.

"I generally hate the idea of people borrowing from a 401(k) to purchase a home, given the possible risks," says JP Geisbauer, a certified financial planner and principal of Centerpoint Financial Management in Irvine, California.

Yet Nathaniel Moore, a certified financial planner and president of Agape Planning Partners in Fresno, California, says he understands why someone would be tempted. "If it means going from paying high rent to getting into a place you own, I get it," he says.

Here's what to consider if you're thinking about it.

Rules for borrowing

Most 401(k) plans permit loans, but federal law doesn't require them to. Log on to the website where you track your 401(k) to find loan information or contact your employer's human resources department or plan administrator.

Some loan terms vary among employer plans, but all plans must abide by federal rules:

• Loans are capped at $50,000 or 50% of the vested account balance, whichever is less —  or up to $10,000 if 50% of the vested balance is less than $10,000. If your balance is $200,000, you may be able to borrow up to $50,000. If your vested balance is $70,000, the maximum loan amount would be $35,000.

• You have a set amount of time to repay the loan plus interest; otherwise, it will be considered a distribution or withdrawal. You'd pay income tax on a distribution and, if you're younger than 59 1/2, an additional 10% tax penalty. The plan sets the interest rate, typically 1% or 2% above the prime rate. 

• Generally, 401(k) loans must be repaid in five years, but a plan can give more time to repay a loan for purchasing a primary home. Payments must be made at least quarterly over the loan term. 

• If you get fired or quit your job, the plan can require you to repay the full outstanding loan balance. If you can't pay, the unpaid amount will be subject to taxes and, if you're under 59 1/2, the 10% tax penalty. You can avoid the tax implications by rolling over the outstanding balance to an IRA or another eligible plan by the next annual federal tax filing deadline. About 4 in 10 Vanguard plans allowed participants to continue repaying loans after leaving their jobs in 2021, according to a 2022 Vanguard report.