How to Use a 401(k) for a Home Loan

A 401(k) plan loan could help you buy a home.

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Borrowing from your 401(k) plan could be the difference-maker in getting you into your dream home, especially if banks are tight with their lending requirements or your credit score is not what it could be. Though you have to pay interest on the loan, you'll essentially be paying yourself because the payments, including interest, goes back into your 401(k) plan loan.

Extended Repayment Period

Generally, you have to repay 401(k) plan loans within five years, and if you don't anything not repaid counts as a distribution. However, 401(k) plan loans used to buy your primary residence are not restricted by the five year limit, so you can take longer to repay the loan. If you prefer to repay the loan over 15 years, you can do so. To qualify, the home must be your primary residence.

Loan Size Limits

Using a 401(k) plan loan for a home doesn't allow you to take a larger loan than a loan you use for any other purpose. Therefore, you're limited to borrowing no more than $50,000 or 50 percent of your vested account balance. For example, if you have a vested account balance of $78,000, you could borrow a maximum of $39,000 for your home loan. These limits apply to all of your 401(k) plan loans together, so if you're already borrowing the maximum from your plan, you can't borrow more.

Failure to Repay

Generally, employers take money out of your paycheck to repay the loan. However, if you don't repay the loan as agreed, the IRS treats it as if you took a distribution equal to the remaining balance on the loan. For example, if you still owe $20,000 on your loan, you'll have to include $20,000 as a taxable 401(k) plan distribution. In addition, if you're not at least 59 1/2 years old, you'll owe an extra 10 percent penalty on the early distribution.

Early Due Date

If you leave your job, even if it's not by choice, you have to repay the loan immediately. For example, if after a few years you get laid off from your job because of a recession and you still owe $35,000 on the loan, you have to come up with that $35,000 immediately or that $35,000 is deemed a distribution for tax purposes. As a result, you'll have $35,000 in extra taxable income that year plus, unless your 59 1/2 years old, a $3,500 tax penalty.