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Should I borrow money from my 401(k) plan for a down payment on my home?

Posted by Jamie Downey  December 8, 2008 08:45 AM

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I am planning on selling my townhouse (fingers crossed) and buying a single family for $350,000. I don't quite have the 20 percent down and wanted to take a "loan" of $15,000 from my 401K to make up the difference so that I don't have to pay private mortgage insurance (PMI). Do you think that it would be cheaper to pay the PMI than to take a loan?

Lenders usually require private mortgage insurance (PMI) on home loans in which the down payment is less than 20 percent of the value of the home. The cost of PMI depends on your down payment, but ranges from approximately 0.35 percent of the value of the home (with approximately a 15 percent down payment) to approximately 0.75 percent of the value of the home (with approximately a 5 percent down payment.) PMI is tax deductible to the home owner if your household income is less than $100,000. Let’s determine your total annual cost of home ownership under each scenario and determine which one is the better option.

Under the first option, you will make a down payment of $55,000 and borrow the remaining $295,000 as a first mortgage on the home. Since your down payment will be less than 20 percent, you will be required to pay PMI. A 30 year fixed mortgage for $295,000 at 5.6 percent will have a monthly payment of $1,693. Additionally, you will be required to pay PMI, which will cost approximately $100 per month. Based on this calculation, your total annual cost will be $21,516 per year of which approximately $17,200 will be tax deductible mortgage interest and mortgage insurance. After approximately four years, you should have 20% equity in the home, at which time PMI will no longer be required.

Under the second option, you will make a down payment of $70,000. You will borrow $280,000 as a mortgage on the home and will borrow the other $15,000 from your 401(k) plan. A 30 year fixed mortgage for $280,000 at 5.6 percent will have a monthly payment f $1,610, of which approximately $1,300 will be tax deductible interest. Additionally, you will pay approximately $290 per month for five years to pay off the loan from the 401(k) plan. None of the loan from the 401(k) plan will be tax deductible. Based on this calculation, your total annual cost will be $22,764 per year of which approximately $15,600 would be deductible.

The first option and paying the PMI certainly appears to be preferable to me. For the first five years of home ownership, you will have less cash outflows. Further, you will have higher tax deductible expenses. Finally, borrowing money from a 401(k) plan carries some risk in that if you leave your job, you will be required to pay the loan back in full. Otherwise the remaining loan balance will be considered a distribution from the plan subject to tax and possibly excise tax.

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D. Abraham Ringer is a CERTIFIED FINANCIAL PLANNER practitioner and a Financial Adviser with Morgan Stanley Global Wealth Management in Boston. He is registered in MA, NH, NY and several other states to which his articles are directed. For more information please visit www.morganstanleyfa.com/ringer
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