As of August 14, 2020…
- Mortgage rates are at or near all-time lows across the US.
- For many, work no longer requires a long commute or physical office in the city.
- Many Millennials are now reaching their prime home-buying/family starting years.
- “Everybody’s doing it!”
While not all of the above are great reasons on their own to buy a home, each of these stars seem to be aligning and leading to a lot of speculation about the possibility of a coming housing boom. Whether these predictions prove to be true or not, interest in home-buying has begun to skyrocket, particularly among first-time homebuyers.
If you fall into this category, you may be wondering where to even begin planning for such a big financial step. And while the process of purchasing a home can certainly get very complicated, let’s just start at step one – your down payment. In other words, where are you going to get the money to buy?
As a general rule, a 20% down payment should be your goal, as this eliminates the need for you to purchase Private Mortgage Insurance (PMI) with your mortgage, which can cost you hundreds of extra dollars each month, on top of your mortgage payment.
So, if your goal is to save 20% for a down payment and the median house price in the US is currently around $250,000, you’re looking at a goal of saving $50,000 cash for a down payment!
For most of us, a goal like this would take years to accomplish, especially if you’re starting at $0. So it’s understandable that many will look to other sources, like tapping into retirement savings. But there are some important things to consider before you take this route to home ownership…
You’re robbing your future self
Maybe a bit of a harsh way to look at it, but draining your current retirement savings will reset the clock on the compound growth of your investments, and a large withdrawal for a down payment today will mean a much larger chunk will likely be missing from your balance when you retire. Let’s look at an example…
Let’s say you have a $100,000 401k balance today and are considering a $50,000 early withdrawal or 401k loan to use for a house down payment. That remaining $50,000 in your 401k could grow to over $360,000 in 30 years, assuming a 7% annual rate of return.
Now, if you didn’t touch that money and instead let that full $100,000 continue to compound and grow at that same 7% per year for 30 years, it could grow to over $760,000! So by taking $50,000 out of your 401k today, you are quite possibly taking $360k away from your future self. Not to mention the fact that a withdrawal will also require paying income taxes on the amount. There goes another chunk of your nest egg!
Many will argue that this isn’t exactly a fair take, given that the down payment on a house is giving you the ability to purchase an asset that is also likely to appreciate over the next 30 years. It’s a fair point. And it leads us to another important consideration…
Will this be a home or an investment?
The way you view this milestone purchase is key. Far too many people jump into home ownership expecting to reap huge returns on their initial investment in a relatively short amount of time, thanks in large part to HGTV. This is certainly possible, but it’s a risky proposition and it requires time and effort many first-time home buyers, especially those with young children, simply do not have.
If you’re thinking of your purchase primarily as an investment, it’s important to also consider that the long-term actual returns for real estate really haven’t been that great, in aggregate.
Although individual markets can obviously vary widely, as a whole US home prices have increased roughly 3-4% annually for the last 25 years, according to the Case-Shiller Home Price Index. This is far less than annual returns of the stock market over the same period. And that rate is the gross nominal price appreciation, which doesn’t account for the costs of home ownership, like taxes, interest on your mortgage, maintenance, updates, etc. Basically, home prices have barely been able to outpace inflation nationally, over time.
All of that is not to say that buying a home is a bad financial decision. In fact, buying a home can be one of the most important steps anyone can take toward building lasting wealth. And one of the biggest benefits of owning vs. renting is NOT actually price appreciation of your home, but the forced monthly savings from the principal portion of your mortgage payment building equity for you over time. That said, the timing and the cost, both short-term and long, are what must be weighed heavily.
If you view the house purchase you’re considering primarily as a long-term home rather than an investment, fully understanding the costs and the reality that it’s primary purpose is not to appreciate in value, but to provide you shelter and comfort for many years to come, then this might change your perspective on both the timing of the purchase and the method of financing the purchase – in this case, using your 401k for the down payment.
What are my alternatives?
If you’re considering dipping into your 401k for the purchase of a house, you probably don’t have the cash sitting somewhere else waiting to be put to use on house down payment. But this actually presents another problem worth considering. If you know that the ongoing costs of home ownership can be substantial and unpredictable, but aren’t able to make an adequate down payment without using your retirement funds, then you may not be ready to take the leap into home ownership just yet. And that is OK!
In our opinion, before jumping into home ownership, it’s important to make sure the rest of your financial house is in good standing. First and foremost, make sure you have enough set aside in an easily accessible savings account to cover at least 3 months of your current essential living expenses. In other words, get an emergency fund. Having this as a fall-back means you are ready for the unexpected, something all homeowners understand the importance of.
Once you have an emergency fund, set a goal to start saving as much as you can in another savings account for your down payment. While the 20% down rule is obviously ideal, it’s not realistic for everyone. We get that. And with interest rates as low as they are today, home ownership is a highly attainable goal for those willing to plan ahead a bit. Putting down less than 20% won’t necessarily kill you financially and in most cases is still a much better long-term option than using your 401k to come up with the bigger down payment.
At the end of the day, if you’re set on purchasing a home and don’t have the cash available to make the necessary down payment, there are still better options than your 401k. If you have a Roth IRA, while still not ideal, you may be allowed to withdraw your contributions and also up to $10,000 in earnings tax-free and penalty-free, for the purchase of your first home.
The bottom line
Purchasing a home is a BIG decision and a HUGE financial milestone. But rushing into it before you’re ready or sacrificing your future retirement savings can ruin the dream of home ownership for far too many. Before considering using your retirement accounts to purchase a home, it’s important to weigh the immediate pros and cons and think about both the timing and the long-term consequences of doing so.
Everyone’s situation is different and we know that this is one of the biggest financial decisions you will ever make. If you’re a blooom client, please reach out to our team of advisors to chat more about your own situation and ways you can plan ahead. That’s what we’re here for!
The information is provided for discussion purposes only and should not be considered as advice for your investments. Past performance is no guarantee of future results. Please consult an investment advisor before you invest.