Can you afford a mortgage? One simple way of knowing whether or not you can afford to buy a home is to make sure your budget can sustain it.
The first step to living the dream of being a homeowner is taking a real look at your financial health. What does financial health mean?
1. Look at your Savings- If you have less than 3-6 months of living expenses saved, then resist the tempting late-night home searches and find an online bank that provides liquidity and good returns. Usually, these online banks give you returns that are four or five times better than you get at your local bank or credit union. By starting to save more, you can better your overall financial health and you can be well on your way to having enough money saved in order to buy a home.
2. Review your Spending – Most individuals don’t dream of budgeting when wanting to buy a home, but in virtually all cases, it is vitally important to know where you are spending your hard-earned income. This also helps you recognize if you can “trim the fat”. This means that you may potentially find dollars in your budget that you can save, rather than spend, when preparing to buy a home.
3. Check your Credit- Another good rule of thumb is to keep your Debt to Income (DTI) under 43%. This means that your current debt (student loans, credit cards, car loans, etc.) should be no more than 43 % of your overall income. Oftentimes, the best way to look at your DTI picture is to take a look at your Credit Report.
4. Get pre-approved – A great way to test your financial health’s temperature is to have a lender pre-approve you. As a result, you will know what you can afford and potentially what skeletons are in your financial closet.
What if I need help coming up with a down payment for a home purchase, can I use my 401K?
The quick answer is yes, but the real question is, should you? While you can take dollars from a 401K account to use as a down payment on a home, it can be tricky and it may not be worth it. Typically, if you are under 59 and a half years old, there is a 10% penalty to withdraw from your 401K. However, if you are a first-time home buyer, there can be some exceptions.
1. Take a loan from your 401K – If your plan provider allows it, you can loan up to the lesser of $50,000 or ½ of your overall balance. Even though it is a loan to yourself, you must pay yourself back… with Interest! Interest is usually prime plus
1 to 2 percent. If you have questions about taking a loan from your 401K, please
\reach out to your trusted financial expert – as always, if you need assistance, we
are more than happy to serve you.
2. A 401K Withdrawal – If your plan provider does not allow loans, or you are a first-time home buyer, you can potentially withdraw from your 401K without incurring a 10% penalty. Things can get a bit tricky here, though. This withdraw is technically
a hardship withdrawal and being a first-time home buyer may not qualify you for
this hardship withdrawal. Keep in mind, whatever amount you are able to
withdraw in the form of hardship is subject to tax because it is added to
your income in the year the withdrawal is made.
Either way, the cost of relying on your 401K for a down payment can really reduce your retirement savings. Not only now, but in the future.
For example, if you have $20,000 in your retirement account, and take out $10,000 for a down payment on a home, the $10,000 remaining balance could potentially grow to $100,000 at an 8% annual return over 30 years. However, if the original $20,000 was left alone to grow, given the same 8% annual return for 30 years, you could be looking at an account value of over $200,000! That is quite a difference! Really, you could be robbing future self of a better potential retirement.
Although you would still be affecting your future retirement, there may be other accounts that would be better to withdrawal from than a 401K in the event needing a down payment to buy a home. These accounts are a traditional IRA or a Roth IRA.
If you have an IRA, there are special provisions for first-time homebuyers and those who have not owned a primary residence for more than two years.
If you have a Roth IRA, you can withdraw contributions if the contribution was made over 5 years ago. If it has been less than 5 years, you can still apply to withdraw funds through a hardship. Plus, for a first-time home purchase, you can withdraw up to $10,000 of earnings tax-free!
If you own a traditional IRA, you can take a $10,000 distribution without penalty. Although, the $10,000 would be added to your taxable income for the year in which the withdrawal was made.
Ultimately, buying a home and applying for a mortgage comes down to budgeting and saving hard-earned cash. This budgeting and saving establish a strong foundation for home buying. In order to not affect your future retirement, withdrawing from your retirement accounts, whether it be a 401K or an IRA, should only be considered as a last resort option.