According to the National Association of REALTORS® 2013 Profile of Home Buyer and Sellers, 8% of first-time buyers borrowed from their 401(k) retirement accounts as a source of downpayment money. It's a good bet that a significant number of potential first-time buyers, as well as others, are not acquainted with how this works. It's also a good bet that, among those with the ability to use 401(k) funds, many are not familiar with the pros and cons of doing so.
Not every 401(k) plan allows for borrowing. (Just one reason to talk first with the plan administrator.) Of those that do, typically the amount available for borrowing is the lesser of $50,000 or one-half the value of the account. In some cases, plans allow for a larger amount to be borrowed if it is to be used for a downpayment on the borrower's home.
In most cases, the loan must be repaid within 5 years. While you don't have to go through typical qualification procedures and pay loan origination costs -- it is, after all, your money and not that of some third party -- there are still implications to this new occurrence of debt. It is likely to affect your ability to qualify for a mortgage and/or the amount of mortgage for which you can qualify. This is something you will want to check out with your mortgage lender.
You will pay interest on your 401(k) loan, but it will be interest you are paying into your own account. Typically, the interest rate will be low, maybe a couple of points above prime. Perhaps you will not be earning as much as the account's typical investment return, but the money will be earning something. However, the interest you pay to yourself on your 401(k) loan is not tax deductible; whereas the interest on a mortgage loan would be.
There is no penalty for this withdrawal of funds in the form of a loan. However, if you are unable to repay it, there will be the standard 10% early withdrawal penalty (if you are under 59½), and the amount withdrawn will be treated as taxable income. Moreover, if you lose your job with your current employer, you generally must repay the loan within 60 -- 90 days. Otherwise, the penalties kick in.
Not surprisingly, among writers on financial matters, there is a wide range of opinions as to whether or not it is a good idea to borrow from these retirement funds in order to finance a home purchase. The chief negative focuses on the loss of earnings growth. This is especially relevant because it is unlikely that most people would, or would be able to, continue their 401(k) contributions during the period they were also paying back the loan. Thus, not only would the amount withdrawn not be earning the fund's annual return, there would not be new money coming in to earn that return.
There is also a "double-tax" factor to be considered. When making loan repayment, the interest paid will be with after-tax dollars. Then, when those dollars are ultimately withdrawn, they will be taxed again.
On the other hand, if one assumes even a conservative appreciation rate over the years, it must be acknowledged that the borrowed downpayment money will get good returns on a highly-leveraged, (still) tax-advantaged investment. Nor should the non-economic social and psychological benefits of home ownership be overlooked.
Borrowing from a 401(k) to help finance a home purchase is not a slam-dunk option for those who have such plans. There are several considerations that need to be examined. If it is an option, though, it is worth the effort to examine them.