401(k) loans and down payments: the debt that doesn’t count against you

When you borrow from your own 401(k), you are borrowing your own money. No lender takes a risk on you, nobody runs your credit, and the loan does not appear on your credit report. If you stopped paying, the plan would take what is owed out of your balance.

That structure is why it lands differently in a mortgage file than any other debt, and it is where I will start. If you want the wider picture on how lenders count what you owe, my guide to debt-to-income sits alongside this one.

What a lender does with the payment

Fannie Mae’s Selling Guide, in the section on monthly debt obligations, addresses a loan secured by your own financial assets:

So the payment leaves your account every month and does not enter the ratio that decides how much house you qualify for.

What that is worth depends on your ratio and your term. Take a borrower at $15,000 a month gross carrying $1,200 in car and student-loan payments, against a 45% total-debt ceiling. A $50,000 plan loan runs about $478 a month over fifteen years, or about $1,014 over five.

• If the payment counted: $6,750 of allowable debt, less $1,200 of other debt and $1,014 for the plan loan, leaves $4,536 for housing.
• As it is actually treated: only the $1,200 comes off, leaving $5,550 for housing.

Using the five-year payment, the larger of the two, that is $1,014 a month of preserved capacity. With taxes and insurance at roughly a quarter of a housing payment, the rest supports something near $120,000 more loan at 6.5% over thirty years — about $150,000 of purchase price at 20% down.

Round assumptions rather than a quote. Tax and insurance loads vary by county, and ceilings move with the rest of the file.

How much you can borrow, and over how long

The IRS caps a plan loan at the lesser of $50,000, or the greater of $10,000 and 50% of your vested balance. Two tests rather than one: a $70,000 vested balance caps at $35,000, while a $200,000 balance caps at $50,000.

Repayment is normally five years. A loan used to buy your principal residence may run longer, and many plans allow fifteen. Mine does, and I have used it. On $50,000 at a typical plan rate of prime plus one:

• Fifteen years — about $478 a month, and $86,009 returned to your own account.
• Ten years — about $607 a month, and $72,797 returned.
• Five years — about $1,014 a month, and $60,829 returned.

Whether your plan offers the longer term is a question for your administrator. Plans are permitted to allow it; they are not required to, and the rate is theirs to set.

Where the interest goes

The interest on a plan loan is paid to you. There is no bank on the other side of it, so every dollar lands in your own retirement balance, which is what the third column above is counting.

It is not free money. Those are after-tax dollars out of your own pocket, and it behaves more like forced saving at the plan rate than a windfall. The interest is also taxed again on withdrawal — about $10,829 over a five-year term, so roughly $2,599 at a 24% bracket, spread across the decades until you retire.

Set against paying $25,000 of interest to a bank for the same use of the same money, I take that trade most of the time.

Two situations from recent files

An IRA about to be cashed out. A couple I closed for recently had decided to liquidate a $34,000 IRA for their down payment, both of them well under 59½. The penalty alone would have run about $2,400 — the first $10,000 is exempt for a first-time buyer, the remaining $24,000 is not. On top of that, the full $34,000 counts as ordinary income in the year they take it, which depending on their bracket is several thousand dollars more.

The husband had a 401(k). You cannot borrow from an IRA at all — the IRS treats it as a prohibited transaction, and the account stops being an IRA as of the first day of that year. A plan loan repaid on schedule is not a taxable event. Same $34,000, about $325 a month, all of it returning to his own balance.

Closing the gap to 20% down. On a $500,000 purchase with 15% saved, the loan is $425,000 and carries PMI. At $400,000 it does not. The gap is $25,000.

• At 15% down: about $2,686 of principal and interest at 6.5%, plus PMI.
• At 20% down, funded by a $25,000 plan loan: about $2,528 of principal and interest, plus roughly $239 a month on the loan.

Your PMI number depends on your credit and your loan-to-value, so I am not going to put one in an article. On the files I see it lands where the second path is cheaper in total outflow — and $239 of what you pay under it comes back to you instead of going to an insurer.

PMI is not permanent. It comes off at 78% of original value, or sooner on request at 80%, and there is a separate piece on how to make that happen. The plan loan runs its full term, so over a long horizon the comparison narrows.

The two ways it goes wrong

Miss the payments and the outstanding balance is treated as a deemed distribution: taxable income that year, plus the 10% additional tax if you are under 59½.

Leave your employer with a balance outstanding and the loan is offset against your account, which is a taxable distribution unless you replace the money with a rollover. This is the more common of the two, because people take a plan loan expecting to stay put.

If your visa depends on your job

A large share of my files are H1B professionals, and the offset rule carries more weight here. When a plan loan is offset because you separated from your employer, and the offset happens within twelve months of that separation, it is a qualified plan loan offset:

• An ordinary offset: 60 days to roll the amount into an IRA or a new plan.
• A qualified plan loan offset: until your tax filing due date, including extensions, for the year the offset happened.

That is a tax rule rather than immigration advice, and I am not the person to give you the latter. What I would say is learn the phrase before you need it, and call a CPA the week the job changes rather than sixty days after. The rest of how these files work is in H1B and visa-holder mortgages.

What I would need to know about yours

Three things decide whether this is worth doing on your file, and none of them can be answered from a web page:

• Whether your plan allows the longer repayment term for a home purchase, and at what rate.
• What PMI would actually cost you at your credit and your down payment, since that is the number the swap turns on.
• How secure the job feels, because that is the one input that changes the answer completely.

Send me those three and I will run it both ways, including the times the answer is that you did not need to touch the account.

Two neighboring pieces, if they apply: using assets as income, for when a retirement balance can support a loan without you borrowing against it, and bridge loans. When it is time to gather paperwork, the document checklist will tell you which statements a lender needs.

General information about mortgage financing, not tax or investment advice. Plan loan limits, repayment terms and whether a longer term is available for a home purchase are set by your plan document and your plan administrator. Tax treatment of distributions, offsets and rollovers is a question for your CPA, and the figures above are illustrative rather than a quote. Agency treatment of debts secured by financial assets varies by loan type and investor guideline. Forest Hills Mortgage LLC, NMLS #1982611. Matt Mergo, NMLS #563819. Licensed in Florida, Pennsylvania and Texas. Equal Housing Opportunity.