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 $86,900, according to the Federal Reserve's 2023 Survey of Consumer Finances, based on triennial survey data collected between 2019 and 2022. The median value of transaction accounts, such as savings, checking and money market accounts, was $8,000.

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 given the potential risks. However, others understand the temptation, particularly if you’re shelling out a hefty sum for rent and would prefer to put that cash toward home equity rather than padding a landlord’s pocket.

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. For example, 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 laid off 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. Over half of 401(k) plans (55%) reported allowing participants to continue repaying loans after a job separation, according to a Plan Sponsor Council of America (PSCA) 2024 plan-year survey.

Risks of using a 401(k) loan

Even if you're convinced a 401(k) loan is the way to go, it's important to understand the risks at the outset.

One is the potential tax burden if you can't make the quarterly loan payments or leave your job and can't repay the outstanding balance on time.

You could also fall behind on saving for retirement. Besides losing potential investment gains on the borrowed money, the loan repayments could crimp your ability to contribute to your 401(k). In fact, some plans don't allow employees to make regular contributions until the loan is paid off. Pausing contributions would be especially costly if you missed out on matching contributions from your employer.

Another less-obvious risk? Once you’ve taken out a 401(k) loan, it can be tempting to tap into your retirement plan again, rather than leaving it alone to do what it’s designed to do: provide income for your future.

Loan costs, repayment and alternatives

Take these steps if you're thinking about borrowing from your 401(k):

1. Check your plan's rules for 401(k) loans

Get details about the interest rate, fees, payment amounts and how long you'd have to repay the loan.

2. Calculate whether you can afford loan payments

Tally the loan payments along with other obligations.

Considering 401(k) loan payments come straight out of your paycheck, make sure your take-home pay can still cover new home costs, everyday expenses and a comfortable lifestyle. Otherwise, you risk having to lean on credit cards to make up the difference — an expensive fix that can further exacerbate your debt.

3. Learn what happens if you leave your job

If the plan requires paying the outstanding balance in short order — as most plans do — strategize how to repay that sum to avoid tax consequences.

4. Consider alternatives

Finally, rather than using a 401(k) loan, check out other options to help buy a house, such as low-down-payment mortgages and your state's first-time home buyer programs, which offer down payment and closing cost assistance. These programs also offer low-down-payment loans from approved lenders.

Some conventional loans have down payments as low as 3%. FHA loans, insured by the Federal Housing Administration, have down payments as low as 3.5%. And if you're a service member or veteran, you may qualify for a zero-down-payment VA loan backed by the U.S. Department of Veterans Affairs. USDA loans for rural home buyers also don't require down payments.

Still want a 401(k) loan?

Despite the potential pitfalls, if a 401(k) loan still feels like the right move for you, here are some essential tips to keep in mind: