Over the last few years, it’s been getting more and more difficult for first-time homebuyers to find a property they can afford. In many parts of the US, home prices have been rising at twice the rate of inflation and wage growth has remained stagnant almost across the board. At the same time, mortgage interest rates have been climbing after spending years at or near historical lows.
Despite the challenging environment, though, demand in the real estate market has only continued to grow. Troublingly, many Americans are taking risks to finance home purchases that are out of their price range, and they’re raiding their retirement funds to do it. That’s almost always a bad idea, with consequences that can reach well into the future. Here’s why.
Right now, the millennial generation makes up the majority of the first-time homebuyer market. They comprise a buying cohort that’s typically on the lower end of the wage scale, are burdened by education loan debt and have the least in savings. That goes a long way towards explaining why some would turn to their retirement savings accounts or 401k plans as an alternative source of financing to purchase a home.
The problem that millennials face is that most of them are already behind the curve in retirement savings, making each dollar they withdraw or borrow against that much more significant. It’s also worth noting that the rules governing penalty-free borrowing from retirement accounts are not always easy to satisfy over the long term, and failure to do so can carry some significant tax consequences, too. That combination of factors can amplify the financial harm that borrowers will suffer in retirement if anything doesn’t go to plan – and things rarely do.
Borrowers that tap a 401k plan to finance a home are taking some pretty significant risks. Besides the fact that removing money from a retirement account might mean jeopardizing retirement income, there are other risks in the near term. Chief among these risks is the fact that any 401k loan that goes into default will convert the outstanding balance of the loan into the equivalent of an early withdrawal. That immediately triggers income tax liability on the funds, with a 10% penalty on top of it.
It’s very important to realize that there’s more than one way to default on a 401k loan. Like conventional loans, failure to make the agreed-upon payments over the life of the loan can trigger a default, but there’s a much larger danger lurking here. Due to the rules governing 401k loans, if you lose your job for any reason (layoff or termination with cause), your loan must be paid back in full by October of the following year. That means that losing a job might condense what was a five-year repayment schedule into a matter of months, with a steep penalty for failure.
The US is not the first country to run into a housing market with the odds stacked so heavily against first-time buyers. Homebuyers in the UK have been dealing with a similarly unbalanced market for years, and retirees there are already starting to feel the pain of decisions to borrow against pensions that they made decades ago. In some cases, retirees are even on the verge of losing their homes.
Reputable mortgage comparison site in the UK almost always advises against the very kinds of arrangements that are becoming popular in the US, because they’ve seen the consequences firsthand. What’s most instructive for Americans in the UK example is that as of now, there’s still no government plan to help those that have compromised their pensions through borrowing to buy a home – which seems like the likely outcome here, as well.
The bottom line is that buying a home today by literally mortgaging your retirement security is a bet that won’t pay off. Between elements of risk that are beyond the control of the borrower, to market forces that can be unpredictable at best, the possible downsides make borrowing against retirement savings a very, very bad idea. For those stuck in the unenviable position of finding that buying their first home remains out of reach, it is far better to wait for more favorable conditions in the market than to take a chance that could lead to long-term financial ruin. Nobody likes to live within limited means, but in this case, it sure beats the alternative.