Borrowing Against A Retirement Plan To Make A 20% Down Payment

My wife and I are currently contemplating an interesting question: should we borrow against our retirement plans in order to make a 20% down payment and avoid PMI or an adjustable rate mortgage? We’ve arrived at an answer to this question, but it’s not an answer that works for everyone, so let’s work through the process we used before we reveal our decision.

First, we calculated what we’re going to spend on a home. We are currently looking at a $175,000 home. This means that a 20% down payment would be $35,000. We have easy access to a significant portion of this, but we would prefer to leave it as an emergency fund, so we’re going to use $5,000 of this for part of the down payment. This means we have to come up with $30,000 to avoid paying PMI.

Next, we estimated what our PMI would be per month. We used the GoodMortgage.com PMI calculator, calculating the sale price of the home at $175,000, our loan amount at $170,000, and our interest rate at 6.25% at 30 years, and it estimated we would have a monthly PMI payment of $147.33. It also estimated a monthly principal and interest payment of $1,046.72.

Then, we estimated what our payments would be per month with the full down payment. If we had the full down payment, we would be borrowing $140,000 on the home, which gives us a monthly principal and interest payment of $862.00 at the same rate over the same period.

How much more does it cost to not have the full down payment? Each month with PMI, we would spend $1194.05, while without PMI, we would spend $862.00. The difference in monthly payments is $332.05. However, what we’re really concerned about is how much each month goes towards equity, so we used the Bankrate.com mortgage calculator to see how much goes towards equity in each situation. We selected a few months during the life of the mortgage for comparison. With the PMI, we would be putting $161.30 towards equity the first month, and unless we overpaid (which makes things much more complicated), we would lose the PMI payments in the tenth month of the tenth year of the mortgage, at which point we would be putting $316.91 towards equity. On the other hand, without PMI, we would be putting $132.84 into equity, and in that magic tenth month of the tenth year, we would be putting $260.98 a month into equity.

What that means is that in the first month with PMI, we would be paying $1,032.75 to the bank with no real return, while at the magic month when PMI goes away, we would be paying $729.81 in interest. On the other hand, without PMI, we would be paying $729.16 in interest the first month, and $601.02 during that magic month.

In short, over the term of the PMI, we would be paying about $300 more a month in interest/PMI, and even after the PMI ends, we would still be paying about $125 a month in extra interest without borrowing, a point we wouldn’t arrive at for almost eleven years.

PMI is really going to hammer you guys. What about borrowing against retirement? My retirement plan allows me to borrow $30,000 for a home purchase at 4.125%, but it has to be repaid in ten years. Thankfully, this is a cash loan – my actual retirement investments are merely collateral for this loan. If I take out that loan, I will have to make a monthly payment of $305.52 per month for ten years, then it’s repaid. At that rate, the first ten years of the loan are roughly equal with or without PMI (regardless of overpayments). However, once those ten years are over, we will be saving about $125 a month by borrowing against the retirement account.

Thus, given our situation, we feel we are better off borrowing against retirement than accepting PMI. The key difference for us is that the borrowing does not affect our retirement investment directly and once the first leg of the loan is over (which is equally bad in terms of monthly payments, but we are paying more principal each month with the non-PMI route), we are in substantially better shape.

It is important to note that if our retirement borrowing actually took money from our retirement investments, it would be a completely different story, as investment losses in the retirement account would eat away pretty much all of the gains from the lower interest rate – and probably then some more, too. If you can’t get a loan with your retirement as collateral, you shouldn’t actually borrow directly from your balance.

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  1. efipo.com says:

    I took the PMI hit. My PMI was taken out 3 years and 4 months living in the house. The appreciation and the slight home repairs put my house over the 20% line and the $90 PMI was taken off. Yeah it cost me about $3600, but I ran it thru some calculations and the interest would of been more than the PMI. I just wish I could of rolled the PMI payment in my mortgage so it could of been tax deductible.
    Have you thought of just rolling the PMI in your mortgage?

  2. Josh says:

    Red flag, Trent.

    In almost all cases you can get the PMI taken off the loan when your equity climbs above 20% of the value of the house. This means that once you’ve paid off the difference between your down payment and 20% of the house, or if your house appreciates 25% in value (or that point where those two events converge) you can petition to have the PMI removed. This is surely going to be sooner than 10 years.

    efipo also brings up an interesting point, but one that applies differently to you–in 2007 PMI became tax deductible. I think these issues should lead you to reconsider borrowing versus taking the PMI hit.

  3. MossySF says:

    Another big gotcha in borrowing directly from a retirement plan (versus using it as collateral) is that you have to repay in after-tax money. Hence, $1000 borrowed directly will require $1333 (at 25% tax) of earned income to repay that amount.

  4. phil says:

    Most 401K retirement plans take the money from your account and you pay yourself back (including the interest). The other issue to remember when borrowing from a retirement account like this is that the full balance is due when you leave the company or you pay the 10% early withdrawl penalty + taxes. If the unthinkable happens and you get laid off you could end up in a very tight position having to payoff the loan at a time you can least afford it.

    Also, as a side note: do watch what’s happening in the subprime mortgage industry. HSBC’s announcement today that they will have to increase their estimates of loan defaults by 20% is ominous. That and the fact that another subprime lender goes under just about every other day… this all points to even lower home prices ahead as lenders tighten up their qualifying requirements thus removing about 20% of potential buyers. I don’t know what the housing market is like where you live, but it certainly looks like you can afford to wait for six months to a year (perhaps longer) while you wait for prices to go lower. That would give you more time to save up for a larger downpayment. I too was considering buying this year, but now I’m going to sit it out and watch what happens – I think I’ll get a better deal in six months to a year.

  5. alandr7 says:

    Borrowing money from a 401k can be extremely risky! You will be taxed on the amount pulled out of the account, paying interest (with after-tax dollars) to your account, and if you become unemployed then the remaining balance on any loans are due within 60 days. I would definitely not borrow from a 401k.

  6. Dwight says:

    This might be a dumb question: When you borrow the money from your retirement account and are charged 4.125% interest, who does that interest go to? The company that’s managing your retirement account or is it interest for yourself?

  7. Serena says:

    How about a 10/10/80 plan? That’s what we did to buy our condo and it’s pretty common – 10% down, 10% second mortgage, 80% first mortgage – that way instead of the PMI the second mortgage winds up being about the same payment, and at least it’s going towards paying down your debt, the interest is tax deductible, and putting 10% down instead of 5% wouldn’t be too bad. We did ours through a mortgage company, and it worked out really well.

  8. Jim S. says:

    Also another point to consider is that if at any time in the next 10 years you quit, are laid off or are fired from your current company you will have to come up with the entire balance of the loan from your retirement account…

  9. gmv says:

    Hmm — do this if you must, but I’d either take the PMI hit or defer buying the house.

    Here’s another consideration — if this is a 401(k) you are talking about and if you leave that job (by your own or your employer’s design), they will consider whatever portion of your outstanding loan against the retirement as an early distribution and you will end up not being able to repay that amount as well as taking a sizable tax hit. I’ve had this happen to me due to a layoff and it takes a HUGE chunk of money out of your 401(k) when you leave the job and there is a loan against it. Over the course of 10 years, can you really guarantee that you won’t change your job??

    If it’s against a Roth IRA this isn’t really an issue but then you’re losing out on that magical compounding interest.

    All in all, I can’t support this plan.

  10. TFB says:

    Are you sure you get to keep your investments when you borrow against your retirement plan?

    Most of the plans I worked with will sell your investments and then give the proceeds to you as a check. As you repay the loan, the loan repayments are invested into the funds again. If you get to keep your investments, where does the cash for the loan come from? From your employer?

  11. MM says:

    We bought our home 3 years ago this month. We put 5% down and went with PMI (by the way, that calculator is spot on, it was correct with our figures right down to the penny). Within one year of purchase our home had nearly doubled in value and we we requested the PMI be removed (as Josh explained above). Your housing market and/or your planned upgrades should really be considered before you make a decision. I also think you should also run your figures with a 15 year mortgage.

  12. rob says:

    Wrong wrong wrong. Bad advice, like a lot of the so-called “conventional wisdom” on this site — its just not the complete story. If you can get an FHA or VA loan, then you pay for (FHA or VA) insurance. But you can get it back when the loan is paid off early. In fact, if you take over an FHA loan (that may be assumable) and then pay it off, YOU get the refund of excess mortgage insurance, not the peron who took out the original loan. But the best deal is not pay any mortgage insurance at all, right? and its an added bonus if you do not pay very much as down payment. Well, it turns out if you put a low enough down payment (preferably zero, but let’s say less than 5 percent) then most PMI companies think you are a bad risk and will not insure the mortgage. The result is you can buy the house without any PMI at all. Its a bit harder to do, you have to be bold and work with the lender, but it is definitely the way to go. PMI is just plain and simple — a rip-off.

  13. Trent says:

    Rob: if you are a bad enough credit risk to be denied PMI, but you still manage to get a no-money-down home loan from a lender, your interest rate is going to eat you alive. PMI is intended to make sure that good credit people with strong incomes but very limited immediate liquidity can get into a home. FHA loans, on the other hand, require their own insurance policy that is almost as expensive as PMI (a year of it costs 0.5% of the total value of the loan) that doesn’t go away until the entire loan is paid, plus again the interest rates are substandard. Basically, you’re talking about options for people with atrocious credit to get into a home, but these options aren’t cost effective compared to what people with strong credit can get, even with traditional PMI.

  14. NCN says:

    Can I ask why you don’t simply save up the money for the down payment? If you saved the 1000 dollars a month, you’d have 30K in 30 Months… As for borrowing from your retirement account… Why don’t your just suspend your retirement contributions for a while so that you save up enough for the down payment? I have no idea what your salary is or will be, but I’d just wait until I had the 20% saved up and then I’d make the purchase…

  15. Trent says:

    Also, the “reimbursement” you mention is for money left in escrow, not for the insurance premiums. This happens when people put up good faith money to get a mortgage, but something goes wrong; the person that takes over the mortgage can claim the escrow money.

  16. Trent says:

    I have enough in an emergency fund to write a check for the down payment, NCN. I just don’t feel comfortable wiping out my emergency fund for that purpose, so we’re looking at our other options.

  17. Mission Debt Freedom says:

    What if you only borrowed $10k and took the other $25k from the emergency fund? That would leave you plenty in emergency savings, and minimize the impact of borrowing against the retirement account. Either way, I am with you on avoiding PMI at just about all costs!

  18. Rob says:

    Trent,
    You feel comfortable borrowing the cash – but not comfortable spending your emergency fund?

    Surely you could use the EF to pay the deposit – and then start pumping the money you would have spent on the loan back into your EF account (or into a mortgage offset account – to bring down interest payments)..

  19. TiP says:

    Trent: I’d like to echo the sentiments of most people here. In the current environment it pays to wait and save up more. By that I mean that home prices are not currently rising in most areas and in many areas they are falling. That gives you time to build up your down-payment-fund and you’ll likely pay less than you would if you were to buy right now. The turmoil in the MBS markets (Mortgage Backed Securities) could very well be spreading from the sub-prime (BBB rated) to the higher rated categories. Lenders are in the process of tightening requirements and that’s going to cut out about 20% of the buyers out of the market (about 20% of loans in in the last four years have been subprime loans). Add to that the fact that $1.2Trillion in ARMs are readjusting to higher rates this year and the fallout will be that a good percentage of those folks won’t be able to qualify to refi into a 30year fixed loan. That’s what’s driving up the foreclosure rates. It’s not a pretty picture for people who bought in the last 4 years or so, but for buyers with good credit & cash for a 20% downpayment it should be very good in the second half of the year.

    You’re correct to not dip into your emergency fund, but borrowing against a 401K can be risky (the risks have already been outlined here). The risks could be amplified by a deteriorating economy brought on by the mortgage lending crisis. The tech stock crash of 2000 had a very serious impact on some segments of the economy. This mortgage crisis (for lack of a better phrase) has the potential to make the tech-crash look small.

  20. Trent says:

    We’re basically exploring all of our options and eliminating ones that are plainly worse than others. As far as we can tell, PMI is a poor option for our situation. Now, is it better to borrow at 4.125% rather than tapping into our 5.05% earning emergency fund? We’re not quite sure about that one – and I probably won’t write about it until we’ve really made our decision.

  21. Shaw says:

    As has been mentioned above borrowing against a 401(k) is very risky. I would be shocked if you can retain your investments on the loaned amount. Where do you think the money is coming from? No one is going to loan you money for 10 years at 4.125%. The deal is $30k in investments will be liquidated from your account and you will “pay yourself” 4.125% interest.

    You may want to look into a FHA loan. We have an FHA loan and the way it was explained to me is that when you reach 20% equity all the money you paid for PMI will be refunded. In our case about 1 year after the mortgage was established they couldn’t verify either my wife’s or my income and therefore the PMI was canceled and our premiums were refunded. Luckily this didn’t affect our loan.

  22. Trent says:

    I do not have a 401(k). I am able to obtain a loan using my retirement account as collateral. Let’s say I want to borrow $30K. They’ll loan me $30K at 4.125%, leave my account alone, and simply claim a number of shares equal to $30K as collateral on the loan. If I fail to pay, they’ll take the collateral.

  23. mapgirl says:

    Trent, it’s good to explore your options and I agree that you shouldn’t spend your emergency fund on your down payment. I had a friend whose condo was flooded by Katrina 2 weeks after settlement. His unit was on the 2nd floor and ok, but emergencies are emergencies. You are right not spend your EF on your downpayment.

    I highly encourage you to look at getting a second trust. Often you can fix the interest rate, which is something I did. (I had a blog post about it last autumn.) I did an 80/15/5 when I was making 40% less than I do now. I don’t pay any PMI, but I do have a slightly higher interest rate on the second trust, but nowhere near as bad as a credit card.

    Good luck! I say you should wait another year to save a downpayment if you can, or else go with the second trust scenario. It sounds like you’d be able to pay it off rather quickly.

  24. TiP says:

    For more info on what’s going on in the subprime mortgage market and how that’s going to further impact a slow housing market and the economy in general, here’s a scary read:
    http://www.itulip.com/forums/showthread.php?t=883
    And you can go to the site he got the graph from and see that it’s continued to deteriorate since he wrote it last week.

    Bottom line: It’s a good time to keep saving up for the 20% down.

  25. Carrie says:

    Psychologically, once you go down the slippery slope of borrowing against your retirement now, you will find all kinds of excellent reasons to do so in the future. If you haven’t been able to save up the 20% down payment to forgo the PMI, then you should probably wait to buy the home. The real estate market is going down and the job market is never guaranteed.

  26. Angela says:

    I’d be interested to know what the figures are on an adjustable rate mortgage.

    I come from a country where our equivalent of an ARM (interest rate fixed for x years) is the longest level of fix that you can get on a mortgage, otherwise your interest rate can (and often does) change from month to month.

  27. Debbie says:

    Thanks for sharing your thinking.

    I started with a minimal down payment on a smaller house, so my PMI was lower. Then I made extra payments of $100/month for just over two years. Then I refinanced, changing my 30-year mortgage to a 15-year mortgage at a lower interest rate. By then my equity was much higher so my PMI dropped substantially.

    Note that small increases in your down payment can lead to big decreases in your PMI.

    $ 5,000: $147.33
    $10,000: $107.25
    $15,000: $104.00
    $20,000: $ 67.17

    It looks like some big cut-off points are 5% and 10%:
    5% = $ 8,750: $108.06 PMI
    10% = $17,500: $ 68.25 PMI

    You might want to try re-doing your calculations with 5% down and see if there’s a big difference.

    Remember that you can also pay extra on your principal, since you’re really concerned about how much goes toward equity. When I first got my house, only $30/month was going toward principal, so adding that extra $100/month made a really big difference. In less than three years, I had basically turned my 30-year loan into a 23-year-loan (that’s how much earlier I would have paid off the loan if I quit paying extra from then on).

  28. Jerry says:

    We did an 80/10/10 to avoid PMI (30 year fixed/15-year fixed/10% down). I saw it mentioned before, but in 07 PMI is going to be able to be written off, which sort of defeats the purpose of a 2nd fixed rate loan. The second loan for us was about 1.25% higher than the first.

    One other thing I heard from other people is that you can buy your own PMI and there’s no reason to take the PMI offered by your lender. This might help defer the cost. I did not hear about this until after I had already purchased the home, so I do not know all of the details. Might be worth looking into as well.

    On another note, your loan says they will take off PMI when equity reaches 78% or something like that to get a few more dollars. You will have to make a request to have it removed at 80%.

  29. Rich says:

    Serena had some good advice about the 10-10-80 plans. Have you looked into that or do you feel that’s not a good way to accomplish your goal?

  30. phil says:

    Then there’s this from the Wall St. Journal today:

    “Subprime Lenders’ Miscue Bad Bets May Foreshadow More General Credit Crunch; HSBC’s Household Setback: Is subprime the first shoe to drop? While house prices kept climbing, it was easy enough for homeowners to pay existing loans by refinancing. But across most of the country, home prices are now falling. That’s causing a headache for lenders to the lowest-rated mortgage borrowers. Though these account for 14% of home loans outstanding, according to the Mortgage Bankers Association, problems in this area may foreshadow a more general credit crunch. But the real problem lies with the general decline in lending standards, that occurred during the housing boom. That was a result of intense competition among mortgage lenders. Loans to subprime borrowers as a percentage of total mortgages have increased fivefold since 2002. Underwriting standards have also been cut elsewhere. Witness the rapid growth of “nontraditional” mortgages, such as negative amortization loans, on which the loan principal actually increases in size. These account for around a third of home loans outstanding, according to Loan Performance, a research firm. For mortgage lenders, having behaved rashly when times were great, there’s a danger that they will now become overly cautious.”

    I’m saving up for my 20% downpayment. It’ll probably take another year, but that seems like good timing.

  31. I also did an 80/10/10 when we bought our first condo. Now we’re in an 80% mortgage on our second place. I wouldn’t borrow against the 401k, what if you die, become disabled, or laid off? Then it’s due immediately and you have no EF because you’ll be forced to wipe it out to cover the loan.

    I’d either save a bit more for a DP or go with a 80/15/5. Also PMI is now also tax deductible, no idea if this is a good thing for you or not.

  32. Margaret says:

    For the Canadians out there — you can borrow from your RRSP under the First Time Home Buyers program. However, we are NOT allowed to use RRSPs as collateral for loans. If any institution was foolish enough to take your RRSPs as collateral and it was discovered, you would be deemed to have withdrawn those funds and would be taxed on the entire amount. I found this out on Gordon Pape’s website.

  33. Marie says:

    Hey I work for the state of Texas…and I have a 6 year teacher retirement built up. The thing that concerns me is that Teacher retirement states that you can’t borrow against your own money or take out a loan against your own money. Does anyone know about this or how I can go about getting a loan against my retirement that I already have build up?

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