Dipping into the funds she had amassed in her 401(k) account to make up the remaining difference for her down payment was not a decision that Alyson O’Mahoney embarked on lightly.

After contemplating the benefits and disadvantages of borrowing $40,000 from her retirement account to use for a down payment on her mortgage, the marketing executive for Robin Leedy & Associates in Mpunt Kisco, N.Y. was certain that she making the right choice.

O’Mahoney was undaunted by the prospect of having another bill each month, even though she opted out of discussing this critical decision with her financial advisor -- as she knew he would discourage her.

“It all fit into my debt and income ratio and the bank was fine with it,” she said. “I pay it back automatically with each paycheck and the 5% interest goes to me. It was the easiest process.”

Many financial advisors steer their clients away from borrowing from their retirement, because employers will typically demand that you repay the loan within a short period if you leave your job or get fired. If you can’t pay it back from your savings, then the loan will be treated as a distribution that is subject to federal and state income tax, as well as an early withdrawal penalty of 10% if you’re under the age of 59.5, said Shomari Hearn, a certified financial planner and vice president at Palisades Hudson Financial Group in the Fort Lauderdale, Fla. office.

“If you’re contemplating leaving your company within the next few years or are concerned about job security, I would advise against taking out a loan from your 401(k),” he said.

O’Mahoney didn’t have any qualms about borrowing from her retirement account because she did not incur a penalty. Since she maxes out her 401(k) each year, she believed it was “like reinvesting what was taken out in a better investing environment.”

Benefits of a 401(k) Loan

If you are still short of marshaling the amount you need for the down payment, borrowing from a 401(k) does have its advantages. The risk you take could outweigh your other options such as having to ask your parents for a loan.

Since you are allowed to withdraw up to 50% of the vested account balance or up to $50,000, you can borrow a substantial amount. In qualified retirement plans, the loans usually need to be repaid within five years, but some extend the period out to as much as 15 years when it is used for the purchase of a primary residence, said Hearn.

The current interest rates are relatively low, so your borrowing costs won't cost you as much.

“Although the interest rate is set by the plan, it is typically only one or two percentage points above the prime rate, which is currently 3.25%,” Hearn said. Essentially, you are earning the interest that you are paying, as you are paying yourself by repaying your loan from your own 401(k). Some people view borrowing from yourself as a form of mandatory retirement saving since you are paying yourself the interest instead of a lender.

“If you’re selling bond investments within your 401(k) to fund the loan, you could be earning a higher return by lending to yourself considering most investment-grade intermediate term corporate bond funds are yielding less than 3%,” Hearn said.

[ Click to compare mortgage interest rates from multiple lenders now.]

Borrowing from yourself has its advantages since it is a straightforward process. In some cases, you take out the loan by just calling your plan administrator and filling out a short loan document, Hearn said.

Drawbacks of a 401(k) Loan

Some consumers are eager to purchase their first home, because mortgage interest rates are still relatively low. While lower interest rates means you wind up paying less for the home in the long run, don’t overlook the shortcomings of taking out another loan on top of your mortgage.

As job hopping has become more commonplace, consider how long you are likely to continue working with your current boss, especially if you get a better offer elsewhere. Even worse, if you wind up being downsized or fired, some plans will want you to pay the entire loan within 60 days, and many people can not afford to do so, said Tony D’Amico, CEO of the Fidato Group, a financial advisory company based in Strongsville, Ohio.

Scraping together cash to put a down payment on a loan similar to an FHA with a lower down payment requirement of 3.5% could be a better option, he said.

“This may be a better option than taking the risk of a 401(k) loan, considering the potential disadvantages of opportunity loss and double taxation, even if you think your chances of losing your job are slim,” D’Amico said.

If you accept another job offer, refinancing your mortgage may be difficult when you are facing a time crunch, said David Reiss, a law professor at Brooklyn Law School.

“If you leave your job, the loan will come due, and you will have to figure out how to repay it – potentially just at the time it would be hardest to do so,” he said. “Given that it might be hard to refinance the property on such short notice, you might find yourself stuck between a rock and a hard place.”

Also, the opportunity costs can be much higher than you believe. You are missing out on your contributions growing tax-deferred, said Hearn.

“Considering that the money may not be repaid for 10 or 15 years, the potential compound growth you missed out on could be significant, especially if you borrowed from the equity portion of your retirement account,” he said.

The money you borrowed is being taxed twice since you pay taxes on your salary and are using your pay check to repay the loan. Once you retire, you are faced with paying taxes again on the money being withdrawn.

“If you're in the 25% federal tax bracket both now and in retirement, paying a 50% tax is extremely expensive,” D’Amico said.

Saving for retirement is crucial, since the average consumer does not have enough money accrued by age 65. Since a portion of your new contributions are allocated for the loan, you “ultimately contribute less to your retirement plan,” he said.

[ Click to compare mortgage interest rates from multiple lenders now.]

Without the confidence in knowing her job is secure and having money tucked away in her savings account, O’Mahoney would not have opted for a 401(k) loan.

“We really had most of the down payment saved and could have tapped our savings account, but we liked the idea of paying it back over time compared to taking all out of our savings in a lump sum,” she said. “You have to think long and hard about tapping your 401(K) for anything.”

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