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I'm about to buy a house and am considering two options:

  • Make a 12% down payment and pay for mortgage insurance
  • Take out a 401k loan and make a 20% down payment

I'm having a hard time finding resources that really discuss the pros and cons of each of these options. Most resources that I've found are quite vague.

I understand that with a 401k loan I lose out on growth opportunity, though I've saved a lot in my 401k (12% of my gross income); I'm not worried about losing my job and having to pay back the loan.

So, which is the better of these two options and what additional factors should I consider when deciding between them?

  • 2
    How long is your mortgage? How long do you plan to live there? How long will the repayment take? What money will you lose out on (both from lack of deposit and less interest from a smaller principal?) How much is the PMI per month? – MrChrister Dec 16 '10 at 7:23
  • @MrChrister: Admittedly I was a bit vague; I was hoping for general advice, not specific advice. In hindsight that was rather silly. To answer your questions: 30 years, a long time I hope, between two and three years, both options come out about even in the end, and $150 or so. – James McNellis Jan 6 '11 at 5:41
  • I've appreciate everyone's feedback. I also apologize that I didn't come back to reply and accept an answer until now. It kept slipping my mind. – James McNellis Jan 6 '11 at 5:43
15

I would put down 12% and pay PMI. Either way, you are taking out a loan, with payments against 88% of the value of the home.

I assume the mortgage note would be either 15 or 30 years and the 401k loan would be less (5? 10?).

If you take out an 88% mortgage loan and pay it off at the same pace you would have paid the 401k loan, you'll be down to 80% LTV quickly and PMI will stop. If the housing market rebounds and your house appreciates, you'll be at 80% LTV quickly. If you change jobs/lose jobs your mortgage will be unaffected. PMI is an easily quantifiable risk that is worth paying in this case.

Contrasted with the 401k loan, the job loss/job change risk is great. It isn't just if you lose your job. Maybe you'll find a great opportunity with a great company that has a 401k plan that doesn't allow loans. Will you forgo taking that job because of your 401k loan?

  • Thanks, Alex. You make a convincing argument. (To answer your question, yes, it's a 30 year mortgage and would have been a 5 year 401(k) loan. I can probably get to 80% LTV within about two years, so in the end the costs are about even, but as you point out there are better opportunities if I don't take a 401(k) loan.) – James McNellis Jan 6 '11 at 5:39
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    "If the housing market rebounds and your house appreciates, you'll be at 80% LTV quickly" -- Its important to note that this is at the discretion of the lender. I had my house reappraised and it made my LTV ratio less then 80% and the lender said they only considered the purchase price when it came to LTV ratio. – n00b Jan 20 '16 at 1:13
3

Can you take 2 loans -- an 80% and an 8% loan? Same payments as doing PMI, but the 8% can be paid off in pretty short order and drop payments significantly.

  • 1
    while this was common at one point, in the US it got quite rare after the housing bubble burst and credit tightened up. Many lenders I discussed it with said they would no longer do it. – justkt Dec 22 '10 at 14:27
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Borrowing against your retirement is borrowing against your future -- you shouldn't do it expect for the most serious financial crises.

The market is down, and 12% is a pretty darn good down payment. You'll hit the threshold where they waive PMI in a few years when you hit 80% LTV, or when you get the house appraised when the market heats up again.

Another option is to find a lender that doesn't do PMI. A few local banks and credit unions do this... I managed to find one in my area that doesn't require PMI or escrowed tax/insurance!

  • +1 Good find. I think the 20% rule is a federal one, but not all loans are federal, so private money might skip the insurance. – MrChrister Dec 16 '10 at 18:05
  • The magic words from my bank is that they are a "portfolio lender". They underwrite all of their mortgages and don't sell the, either privately or to a GSE like Freddie Mac. – duffbeer703 Dec 22 '10 at 13:05
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    All borrowing is "borrowing against your future", no? – RonJohn May 9 '17 at 0:00
7

It depends on how much money it is going to save you, how secure your job is and how much risk is acceptable to you. The main problem with taking out a 401k loan for anything is that you have to pay it back within ~60 days of loosing your job which would be precisely when you need your savings the most and then you get the tough choice of using your savings to repay the 401k loan (assuming you have an emergency fund) or possibly not having enough money to live on until you find another job. If you don't have an emergency fund you are going to get stuck with a substantial tax bill 10% penalty plus taxes at your marginal rate.

There are definitely advantages to avoiding PMI and you will probably get a pretty decent return on investment (mortgage interest rate + cost of PMI), but there are risks as well.

  • 2
    There is also the issue of a sum of money that will no longer be generating interest and growing in retirement. – MrChrister Dec 16 '10 at 7:24

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