Shrinking emergency funds are leaving buyers little choice
As affordability challenges squeeze household budgets even tighter, the ability of families to add to savings is becoming more difficult.
Whether for an emergency or for large-ticket items like housing down payments, households are struggling to put extra money back. A recent US News & World Report survey found 43% of Americans couldn’t pay for a $1,000 emergency expense with their savings.
If they can’t afford a $1,000 emergency expense, they certainly don’t have the savings for a down payment on a home. And while there are down payment assistance programs that can help, some potential homebuyers are considering tapping into retirement funds for a down payment instead.
While many of these borrowers will consult with a financial advisor or tax professional before making this move, others will walk into a mortgage broker’s office and bring up the idea of borrowing from their 401(k) for a down payment. One financial expert has advice for how brokers can advise these potential homebuyers.
Lance Morgan (pictured top), family finance and real estate strategy expert at Legetty, said that the first thing brokers need to realize is that just because someone is looking to tap into retirement for a down payment isn’t necessarily a good or bad thing.
"A broker needs to recognize that using 401(k) funds for down payment purposes does not, by itself, create a positive or negative situation,” Morgan told Mortgage Professional America. “Users will access this service in specific situations because they need to access their money right away, even though they do not understand how these transactions will impact their financial stability in the future.”
Impact on retirement growth
The balancing act for homebuyers to consider is whether the money earned through owning a property and having it appreciate outweighs the lost 401(k) interest income caused by the loan. The move makes more sense when buying an investment property compared to a primary residence.
“Brokers need to understand that the actual evaluation process extends beyond comparing retirement funds to real estate investments,” Morgan said. “They must determine whether real estate investments will generate better returns than retirement savings would have.
“The financial calculations indicate that a client can exchange their 4% retirement withdrawal from a long-term investment for a property that produces equivalent or better cash flow while increasing in value. If they’re just buying a personal residence with no income component, it’s much harder to justify.”
Another concern that some borrowers might have right now is the tax implications of a 401(k) loan in the event of a job loss. Many white-collar workers are concerned right now about AI technology leading to layoffs.
“Brokers need to notify their clients that 401(k) loans operate through separate processes from withdrawal procedures,” Morgan said. “Through loan assistance, borrowers can skip their tax obligations and penalty payments, but they must give up their ability to earn compound interest and must follow all loan program requirements.
“The primary problem occurs when a borrower becomes unemployed, as their loan payments are then considered taxable income. Most homebuyers fail to consider this risk because they concentrate on obtaining mortgage approval.”
More guidance for homebuyers
Because homebuyers who take money out of their 401(k) will be giving up interest income, Morgan said brokers should make sure they’ve explored other options for down payment assistance, especially for primary residences that aren’t investment properties.
“Buyers fail to recognize that taking retirement funds out of their account will lead to permanent financial obligations that continue after their first withdrawal,” he said. “Over a 10- or 20-year period, they’re not just spending principal, they’re giving up decades of growth. The account stops compounding at its previous rate even after the company removes only the interest portion. The trade-off between these two options will remain permanent rather than be a short-term solution.”
For homebuyers who are considering using 401(k) funds to make a down payment on an investment property, Morgan said brokers should advise them not to use those funds as an excuse to buy more house than they can afford.
“The guidance brokers can responsibly give customers comes down to a few decision rules,” he said. “First, you should avoid using your retirement savings to purchase a home that exceeds your budget. Second, the property needs to generate income or create long-term financial opportunities through its use of retirement funds instead of simply increasing the cost of living.
“Borrowers need to evaluate this change by conducting a thorough analysis of their financial condition, which extends past their mortgage loan application process.”
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