Recently, a reader asked us about using 401(k) funds to buy a home:

Whether you should use your 401(k) to purchase a home depends on a number of factors, but borrowing from your 401(k) for anything, including a down payment on a house, can be risky.

In some situations, however, the risk may be worth your while, especially if you’re eager to get into a new home because home prices and mortgage interest rates are on the upswing again.

An Overview of Borrowing from Your 401(k)

As with all tax-advantaged retirement accounts, 401(k)s are complicated products governed by complicated tax laws. Plus, different 401(k) accounts work differently, depending on the rules of the firm that runs the account.

Taking a loan from your 401(k) is taking a loan from yourself. If you’re completely vested, you own all the money in that account, which means that when you borrow from your account, you’re borrowing from yourself.

But taking money out of your 401(k), because it’s tax-advantaged, is more complicated than running to the bank and withdrawing $20 from your checking account. There are hoops to jump through, and you’re required to pay back what you take out, often within a relatively short amount of time.

Borrowing from your 401(k) is further complicated because 401(k) accounts vary from one employer to the next. Even though 401(k) loans are allowed under IRS regulations, your employer sets up the way your account works, and that includes deciding whether to allow withdrawals.

Because 401(k) loans can be a relatively costly feature, many small businesses don’t offer them, though most larger businesses do.

While penalty-free IRA withdrawals are limited to unusual circumstances, that isn’t the same with 401(k) loans. Legally, you can withdraw a certain amount from your 401(k) for just about anything under federal law. But, again, the specifics are up to your employer.

In an effort to help employees maximize savings while reducing their own costs, many businesses restrict 401(k) loans to certain situations. Often, you can only take a loan from your 401(k) to pay for education expenses, to cover unreimbursed medical expenses, to buy your first home, or to dig yourself out of a financial emergency.

So before you decide if you should borrow from your 401(k) to buy a home, you might want to check whether you can.

How it Works

While employers can decide whether and when you can borrow from your 401(k) account, the actual process is pretty standard.

Under the law, you can borrow up to 50 percent of your vested account balance, up to a maximum of $50,000. The typical 401(k) loan needs to be repaid within five years, but if you’re borrowing to purchase your primary residence, the term could be extended to 10-15 years.

When you borrow from your 401(k), there are no tax consequences and no tax-related fees. The process doesn’t involve a credit check, and, most of the time, there’s not much paperwork to fill out. The payments on your loan are usually deducted from your paycheck, so you don’t need to worry about making the payments each month.

As you pay back your 401(k) loan, you’ll repay yourself with interest. Typically the interest rate is variable and is set at the prime rate plus 1-2 percentage points. The best part of this is that the interest is all going back into your 401k account.

Benefits of Borrowing from Your 401(k)

When mortgage rates rise, a 401(k) loan can provide cost-effective access to capital. With interest rates just above the prime rate on most 401(k) loans, this can be a very affordable option to cover a large down payment.

And while we’re on the subject of interest, there’s another benefit of borrowing from your 401(k) for your down payment: any interest you repay goes back to your account.

If you’re concerned about taking money out of high-performing investments to take a loan, don’t be. With most plans, you can choose where your money is invested, within options set by your employer’s plan. When you take money out of your plan as a loan, you can choose to take the money from lower-performing investments.

If you’re choosing between borrowing from your 401(k) or taking a traditional IRA distribution for your down payment, the 401(k) can be a better option. Unlike a traditional IRA distribution to buy a home, a 401(k) loan doesn’t have immediate tax implications.

When you withdraw from an IRA to put money down on a home, you’ll have to pay income taxes on the distribution. But because the money you borrow from your 401(k) is a loan, you don’t need to pay income taxes on it. In fact, it doesn’t count as income at all.

The Downside of Borrowing from Your 401(k)

The most basic problem with borrowing from your 401(k) is that you’re missing an opportunity for your account to grow as much as possible. Even though you repay your account with interest, you may not be repaying the money with as much interest as you would have otherwise earned.

And while 401(k) loans do offer some short-term tax advantages, in the long term, the advantages aren’t as great. The interest you pay back on your loan comes from after-tax dollars, so it’s not tax-deductible.

Also, taking a 401(k) loan can be a huge risk. If you lose your job or leave the company, you’ll likely have 60 days – or, sometimes, a little longer – to pay back the outstanding balance in full. If you can’t pay up, the unpaid balance counts as a distribution, which means you’ll pay both income taxes and the ten percent early withdrawal penalty.

This is the case unless you reach 59 1/2 before leaving or losing your job. In this case, you won’t need to pay the early distribution penalty, just the income taxes.

One final risk with a 401(k) loan is its effect on your future savings decisions. Because the loan payments will likely come out of your paycheck, it’s tempting to stop putting automatic payments into your 401(k) while repaying the loan. But halting your retirement savings for even a few years can have a huge impact down the road.

Is a 401(k) Loan Right for You?

As with all things personal finance, there’s no one-size-fits-all answer to this question. Sometimes, a 401(k) loan is a good idea, and other times it’s not.

The best time to take out a 401(k) loan is when you’re several years from retiring and you have very good job stability. If you meet these basic requirements and are preparing to invest in your primary residence, a 401(k) loan could be a good option for you.

You need to compare your options. Could you scrape together enough cash to put a down payment on an FHA-type loan with lower down payment requirements? This may be a better option than taking the risk of a 401(k) loan, even if you think your chances of losing your job are slim to none.

Or would it be better to wait a few more years to buy a home, so that you can save a down payment without taking money from your 401(k)? But if you need a large down payment and you need it now, taking a loan from your 401(k) could be a good option. You’ll want to look at all the consequences, perhaps with a qualified financial planner.