Savvy Homebuying Option: Take Out a 401(k) Loan, Then Recast Your New Mortgage

Are you in the market to buy a new home? If you already own a home, most of your liquidity may be tied up in that property. You might not have enough cash on-hand to make a down payment on a new home and float two mortgages if you have a sizable loan on the old home. Unfortunately, many sellers may be reluctant to accept a home sale contingency in today's hot real estate market. So, what are your options if you suddenly find your dream home and want to make an offer?

If you wait until your current home sells, you could lose out on a property you love. But if you have a significant balance vested in your 401(k) account, you may be able to tap into it to cover the down payment and the extra mortgage payments until your current home sells. Assuming you've built up significant equity over the years, after closing on the old house, you can then use the sales proceeds to 1) repay the 401(k) loan and 2) "recast" your new mortgage to reduce your payments going forward. Here's how this strategy works and some potential pitfalls to watch out for.  

Phase 1: Your 401(k) Loan

The first step in using this strategy is to take out a 401(k) loan to use for your new home purchase, if your plan allows it. Most plans permit loans if certain conditions are met, but it's not mandatory. After all, this isn't what the plan is intended to provide in the first place.

Note: If your plan allows loans, it can't discriminate in favor of higher-ups. Virtually every participating employee with vested funds is eligible. What's more, the plan can't set different terms for different employees.

You can't take a loan for your full 401(k) account balance. The tax law strictly limits the amount of 401(k) loans to the lesser of:

• $50,000 or
• 50% of your vested balance.

For instance, if you have only $90,000 in vested benefits, you can't borrow more than $45,000. Additionally, the amount you can currently borrow is reduced by any existing loans. So, if you previously borrowed $50,000 and have an outstanding balance of $20,000, you can borrow only up to $30,000 more from your account.

If you're married and your spouse has his or her own 401(k) account, you can each take out separate loans up to the tax-law limit to use for your home purchase. So, if you're both eligible for a $50,000 401(k) loan, you'll have up to $100,000 at your disposal.

Plans generally require you to repay the loan within five years. But some plans have special provisions that allow the five-year period to be extended if the loan is used to purchase a principal residence. Loan repayments must be made on a regular basis (usually, monthly or quarterly). The plan may set the interest rate, but it has to be "reasonable" under the circumstances. Most plans use the going prime rate, which is the same rate banks are charging creditworthy borrowers.

However, borrowing from your 401(k) account and paying interest on the loan can be preferable to a traditional bank loan. Why? You're effectively paying yourself back instead of a lender. All the money you repay—including the loan principal and the interest—ends up back in your own account.

Beware: It can take a couple weeks to submit all the required paperwork with your plan administrator and receive the loan proceeds from your plan. So if you're a serious home shopper, you might want to start this process sooner rather than later. You also may be able to take funds out of an IRA for a home purchase, but different rules apply and there may be tax consequences. Contact your SSB tax advisor if you're interested in this alternative.

Potential Downsides to 401(k) Loans

401(k) loans come with some risks. For example, if you don't repay the loan in a timely fashion, including the interest, the remaining amount is treated as a taxable distribution, subject to tax as ordinary income. Currently, the top income tax rate on ordinary income is 37%. Plus, if you're under 59½, you'll owe a 10% penalty for an early distribution in addition to the regular tax.

Also, if you leave your job—say, to retire or take another job or if you're terminated—you must immediately repay the full amount of the loan. That could be a dicey proposition for people who could lose their jobs or are contemplating switching jobs.

Finally, consider the "opportunity cost" of taking out a loan from a 401(k) to finance a home purchase. The money that you're borrowing would otherwise be invested and earning tax-deferred income if it had remained in your account. After all, a 401(k) account is meant to help you save for your retirement—not buy a home.

Phase 2: Dual Home Ownership

Once you've received the 401(k) loan proceeds and a seller has accepted your dream home offer, you're free to close on your new home and wait (anxiously) for your old house to sell. This can be a stressful time. You're dealing with mortgage, insurance and real estate professionals, along with packing and moving. It's not ideal to pay two mortgages each month, along with other home expenses (such as utilities and insurance). But this setup should be short-lived—your old house should eventually sell.

In addition, owning two properties may temporarily provide you with some breathing room. For one thing, your first mortgage payment on the new home usually won't be due until 45 days after closing. In addition, if you're moving locally, you don't have to move everything into your new home at once. This setup may be helpful if you need to declutter your old house to make it more salable, your kids need to finish the semester at their current school or you want to make improvements to either home. In fact, homeowners with pets may decide to relocate to the new home to avoid the hassle of taking them out of the house every time there's a showing.

If you're having trouble selling your old home, you might have unrealistic expectations about the selling price. In some cases, you might need to lower the asking price or offer concessions—or make some repairs and improvements based on feedback from showings. Worst case, if you can't sell your home at a price you can live with, you could decide to rent it out. But that option has tax implications. If you're considering renting your old home, discuss it with your SSB tax advisor first.

Phase 3: Mortgage Recasting

After you close on the sale of your old home, you're in the home stretch! It's now time to apply the proceeds from the sale to pay off your 401(k) loan. Then, what's left over is available to reduce your outstanding mortgage on the new home and your monthly payment. In essence, recasting—sometimes referred to as "re-amortizing" by some banks—is a form of prepaying your mortgage, a traditional strategy for reducing the overall cost of a mortgage.

With recasting, you make a large lump-sum payment—referred to as "principal curtailment"—on your mortgage balance. Then the lender recalculates the monthly payment based on the new balance, using the same terms, including the interest rate and maturity date.

Important: Some government loans—including Federal Housing Administration loans, Veterans Association loans and U.S. Department of Agriculture loans—can't be recast. Certain jumbo loans also may not qualify for recasting. Check with your lender for its requirements. Typically, lenders establish a specific minimum principal curtailment amount (such as $10,000) to qualify for recasting. And, most likely, you'll have to be up-to-date and in good standing with your existing mortgage payments.

Similar to applying for a 401(k) loan, applying for a mortgage recast doesn't happen overnight. You'll need to:

• Fill out the recasting approval form required by your lender,
• Request a wire transfer to remit the principal curtailment amount to the lender,
• Pay a small processing fee (usually around $200 to $300), if applicable,
• Review, sign and notarize the recasting agreement and send it back to the lender, and
• Wait for the lender to approve the recasting request.

If you stay on top of the paperwork, the process shouldn't take longer than one to three months to complete. In the meantime, be sure to make any required mortgage payments on the original loan.

Important: Depending on the mortgage terms, some borrowers may be required to pay private mortgage insurance (PMI) if their loan-to-value (LTV) ratio is above a set limit (usually 80% or 90%). If you're in this situation and your loan falls below the LTV limit after recasting, you can request a PMI termination. If approved, you'll no longer be required to pay this extra amount. This is one more hoop that you might have to jump through when recasting your loan to get the lowest monthly payment possible.

Be aware that recasting a mortgage isn't the same as refinancing one. (See "Recasting vs. Refinancing," below.) When making your recast request, be sure to submit the appropriate forms to your mortgage company.

Recasting vs. Refinancing

Do you understand the differences between recasting and refinancing a loan? Here's how the two alternatives compare:

Recasting. Here, the terms of the loan remain the same, including the interest rate and maturity date. After you pay a large lump-sum to reduce your principal balance, the monthly payment is reduced through re-amortization of the loan. Banks generally charge a minimal fee for this service. In addition, recasting may be preferable to refinancing if you already have a favorable interest rate—especially if current rates are trending higher.

Refinancing. When you refinance an existing mortgage, you're applying for a new mortgage with different terms. For example, you might want to lower your interest rate or change the maturity date. As a result, you'll incur closing costs comparable to those incurred for the prior loan. However, refinancing at a significantly lower rate can save you considerable money over time. When determining whether you'll recoup the costs of refinancing, consider the size of your mortgage, the monthly cost savings and how much longer you plan to stay in the house.

Contact your financial advisors to discuss which option works better for your situation.

Right for Your Situation?

This strategy isn't appropriate for every homebuyer and comes with potential risks. It works best for buyers who have built up substantial equity in their current homes and have significant balances in their 401(k) accounts. You also need to be patient, diligent and reasonably sure your home will sell quickly. Contact your SSB advisor to crunch the numbers and determine whether this strategy is right for you.

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