Finding a great house often means striking while the iron is hot. Whether you’re rushing to take advantage of an interest rate reduction, trying to buy while your local housing market is affordable or just pouncing on the perfect space in the ideal neighborhood, you can’t always wait to save up for a 20% down payment.

For someone in this situation, it can be tempting to consider using the money you have saved up in your 401(k). But what are the implications of making such an early withdrawal, and what are the alternatives? When is this the right - and wrong - move to make?

Here’s what you should know about cashing out your 401(k) to buy a house.

How to Withdraw Money from a 401(k)

401(k) Loan

A 401(k) loan means borrowing money from a 401(k) and paying interest directly to the account. Borrowers are allowed to withdraw the lesser between $50,000 or 50% of the balance. Some employers may allow you to borrow 100% of the balance if your account has $10,000 or less.

The loan usually needs to be repaid within five years, but this may vary by employer. The term may be longer if you’re using the loan to buy a primary residence, but this won’t apply if you’re buying a vacation home or investment property.

If you lose your job or quit, you’ll then have to repay the loan within 90 days. If you can’t, the remaining amount will count as a withdrawal. You’ll have to report the amount on your taxes and pay a 10% early withdrawal penalty. The penalty only applies if you’re younger than 59.5 years of age.

This is one reason why a 401(k) loan is not ideal for anyone with unstable job security, or plans to leave the company in the near future. You can always make extra payments to repay the loan ahead of schedule.

Withdrawing from a 401(k)

If you don’t want to take out a loan, you can simply withdraw the money you need from your 401(k) - with a 10% penalty and taxes on top.

There is, however, a way to avoid the 10% penalty. If you have a Roth 401(k) and only withdraw your contributions, you can avoid the 10% penalty. The penalty will still apply if you withdraw any earnings, or the money your account has accrued in the stock market. Contact your fund manager to find out your contribution total.

One notable downside to taking a withdrawal from your 401(k) is that the money can’t grow in the stock market. If you take out and repay a 401(k) loan, the money will be reinvested.  

Pros of Withdrawing from a 401(k) to Buy a House

For many people, buying a house is a fulfillment of the American dream - but qualifying for a mortgage can be a nightmare.

You need at least a 3.5% down payment to qualify for an FHA mortgage, or a 5% down payment for a conventional mortgage. On a $200,000 house, that means the minimum down payment can range between $7,000 and $10,000. That amount doesn’t include the closing costs, which are usually between 2% to 5% of the loan.

Consumers looking to buy a house may not have thousands or tens of thousands of dollars saved up, especially when buying in a high cost-of-living city like New York or San Francisco. In this case, taking out money from a 401(k) may be the only way to buy a house in the foreseeable future.

Some borrowers with a low credit score may need a larger down payment to qualify for a mortgage. For example, someone with a credit score below 580 will need a 10% down payment to qualify for an FHA mortgage. For someone in this situation, taking money from a 401(k) may be the only option.

Cons of Withdrawing from a 401(k) to Buy a House

When you withdraw money from a 401(k) to buy a house, you could end up with a surprising tax bill on top of the 10% early withdrawal penalty.

There are also consequences if you take out a 401(k) loan to buy a house. The money you withdraw can’t produce dividends or earnings, which could impact your retirement timeline - especially if you don’t increase your contributions once the loan is repaid.

Since most Americans are already behind on saving for retirement, taking money out of your 401(k) could be more damaging to your financial future than it’s worth. It might be best to hold off on buying a house or lower your budget.

Should You Use Your 401(k) to Buy an Investment Property?

Real estate investors who spot a great opportunity may be tempted to raid their 401(k) for a down payment on an investment property. But this can be a dangerous situation.

Let’s say you take out a 401(k) loan to buy a property that you rent out. The economy then takes a nosedive and you lose your job. Suddenly, you have 90 days to repay the loan or have it count as a withdrawal.

A better choice may be to take out a home equity loan using your current house as collateral. The repayment term on a home equity loan or line of credit is usually longer than a 401(k) loan. Plus, you won’t have to worry about switching employers and being forced to repay the loan within 90 days.

Alternatives to 401(k) Loans and Withdrawals

Investors with an IRA can withdraw up to $10,000 for a down payment on their first home, all without paying the 10% early withdrawal penalty. You’ll still have to pay income taxes, and a 10% penalty on any withdrawal amount over $10,000.

This exception to the 10% penalty can only be used once in your lifetime. If you want to withdraw money from your IRA again, you’ll have to pay the 10% penalty. If you have an old 401(k) from a previous employer, you can roll it into an existing or new IRA. Then, you can take the down payment withdrawal and avoid the 10% penalty.

You can only convert a 401(k) from a past employer into an IRA, not one from a current employer. You can roll over an old 401(k) into an IRA at any time, even if it’s been years since you left the company.