The cost of using funds in a 401K as down payment should be compared with the cost of mortgage insurance and the cost of a second mortgage, with allowance for the risks associated with each option. The best choice can vary from case to case.

Whether you take funds from a 401K to make a down payment should depend on whether it costs more or less than the alternatives, which are to pay for mortgage insurance or for a second mortgage. Account should also be taken of the risks inherent in these different options.

As an illustration, you buy a house for $100,000 and have enough cash to pay only $5,000 down. Lenders will advance only $80,000 on a first mortgage without mortgage insurance. One source for the additional $15,000 you need is your 401K account. A second source is your first mortgage lender, who will add another $15,000 to your first mortgage, provided you purchase mortgage insurance on the total loan of $95,000. A third option is to borrow $15,000 on a second mortgage, from the same lender or from a different lender.

The general rule is that money in 401K plans stays there until the holder retires, but the IRS allows "hardship withdrawals". One acceptable hardship is making a down payment in connection with purchase of your primary residence.

A withdrawal is very costly, however. The cost is the earnings you forgo on the money withdrawn, plus taxes and penalties on the amount withdrawn, which must be paid in the year of withdrawal. The taxes and penalties are a crusher, so avoid withdrawals if at all possible.

A far better approach is to borrow against your account, assuming your employer permits this. You pay interest on the loan, but the interest goes back into your account, as an offset to the earnings you forgo. The money you receive is not taxable, so long as you pay it back.

The cost of borrowing against your 401K is only the earnings foregone. (The interest rate you pay the 401K account is irrelevant, since that goes from one pocket to another). If your fund has been earning 6%, for example, that is the cost of the loan to you. You will no longer be earning 6% on the money you take out as a loan. If you are a long way from retirement, you can ignore taxes because they are deferred until you retire.

The major risk in borrowing against your 401K is that if you lose your job, or change employers, you must pay back the loan in full within a short period, often 60 days. If you don’t, it is treated as a withdrawal and subjected to the same taxes and penalties. 401K accounts can usually be rolled over into 401K accounts at a new employer, or into an IRA, without triggering tax payments or penalties, but loans from a 401K cannot be rolled over.

Borrowing from your 401K should not prevent you from continuing to contribute the maximum amount that can be shielded from current taxes. If it does, the cost goes out of sight.

You can borrow the additional $15,000 you need from the first mortgage lender by paying for mortgage insurance. The cost of mortgage insurance is roughly 5% above the after-tax mortgage rate. (See What Is the Real Cost of Mortgage Insurance?)

For example, if your mortgage rate is 6% and you are in the 35% tax bracket, your after-tax mortgage rate is 6(1-.35) = 3.90%, and the mortgage insurance cost would be about 8.90%.

The cost of a second mortgage is the interest rate adjusted for taxes. If the rate is 9% and you are in the 35% tax bracket, the cost is 9(1 -.35) = 5.85%.

While borrowing from a 401K account involves risk associated with changing jobs, the mortgage insurance and second mortgage options entail risk associated with changing houses. These options reduce equity in your house, increasing the possibility that a decline in real estate prices will leave you with negative equity. This could make it impossible to pay off the mortgages in the event you want to sell the house and move somewhere else.

In most cases, however, the risks involved in reducing your equity in the house are smaller than the risks associated with borrowing from your 401K. If the costs are close to being the same, leave your 401K alone.

Copyright Jack Guttentag 2007