WALNUT CREEK, Calif. – Faced with a real estate market that has tightened up lending standards at a time when home values are dropping, more people are borrowing money from their 401(k) retirement plans to help swing a down payment to buy a home.

But before you think that borrowing from your employer-sponsored 401(k) retirement plan – or a 403(b) if you work for a school or nonprofit – is the ticket to buying a home, this strategy has both pros and cons.

On the plus side, the loan principal, along with the interest on the loan, is paid back to you and is lower (currently in the 6.5 percent range) than what a bank typically charges. Also, there is no credit check required since you are lending yourself the money.

On the negative side, taking out a loan could significantly reduce the retirement account’s long-term growth and earning potential, especially if you stop making contributions while paying off the loan. (That is if you can. Not all plans allow you to make contributions while your loan is active.)

Whether you can actually borrow from a 401(k) is up to the plan sponsor, which is your employer. About half of the plans sponsored by the nation’s employers – which collectively reach about 85 percent of the nation’s 47.2 million 401(k) account holders – allow loans, according to industry statistics. Borrowing is typically capped at $50,000, or up to half of the vested amount, but requires a minimum loan amount of $10,000.

“Borrowing against your 401(k) is a very dumb idea,” said Jim Titus, a vice president and financial consultant in the San Francisco headquarters of financial services firm Charles Schwab & Co. “Number one is the opportunity costs of borrowing. You end up losing the (tax-deferred growth potential) when you take the money out of your 401(k) and the interest you pay back is unlikely to earn as much of a return as your 401(k) investment.”

That said, there are reasons to consider borrowing from a retirement plan to take advantage of the steep drop in home prices in the wake of the mortgage meltdown sparked by the sub-prime loan crisis that began last year. The meltdown has also made lenders reluctant to provide no-money down loans or piggyback lending, which amounts to two mortgages packaged together to finance a home purchase.

“I’m seeing a lot of people touch upon their retirement accounts for down-payment money,” said Dianne Crosby, a senior loan consultant in the Oakland, Calif., office of LaSalle Financial Services, which is both a mortgage banker and mortgage broker. “What’s going on from a lending perspective is that lenders are requiring a much larger down payment than they did a year ago, preferring 20 percent down, accepting 10 percent down with mortgage insurance. But prices are coming down on homes. There is a willingness to tap into retirement (funds). Right now, (with) real estate in a depressed market, I think it’s a great investment.”

One question that people have to ask is whether they would be better off taking out a retirement fund loan now and using it for a down payment or waiting until they accumulate additional funds, said Gary Gardner, a certified financial planner and president of LifeWealth Advisors.

“There are some clear risks of using a 401(k) as a funding source for a down payment on a house. You have to assess those risks and weigh them against the particular economic opportunity you have to buy a home. Under normal circumstances, I think borrowing from a 401(k) to purchase a home is ill-advised. But because of what’s going on in the real estate market, special and exceptional opportunities do arise,” he said. “There are some tremendous values.”

While a 401(k) loan can indeed help provide the down payment on a home, keep in mind that lenders typically treat the money as a form of debt. That could have an impact on your qualifying debt-to-income ratio for the size of the home loan for which you can qualify. The flip side is that using 401(k) money for a down payment could provide the needed equity to avoid paying mortgage insurance.

Retirement fund loans have to be repaid within five years. But there’s no set time frame for paying back the loans if they are used to make a down payment on a primary home.

Given that the stock market has been sliding in recent months, it might be tempting that the interest rate you would pay to yourself on a 401(k) loan could provide a better return than the retirement fund is currently earning.

That’s not a good idea, according to Titus, the Schwab executive.

“In the short term, the interest may outperform the stock market, but it is very unlikely that the interest is going to outperform the stock market over the length of the 401(k) investment,” he said.

The loan is also being repaid with post-tax dollars, not the pre-tax dollars used to fund the retirement fund. So if you’re in the 28 percent tax bracket, you are actually paying back $1,280 for every $1,000 borrowed on top of the loan interest, he said. Also, the interest paid on the loan is not tax-deductible.

There are also several other things to consider.

If an employee ends up losing his or her job, most loans have to be paid back within 60 to 90 days, said Titus. If the loan is not repaid by that time, then the unpaid loan balance is treated as a distribution subject to income taxes and possibly early withdrawal penalty.

So it’s important to think about job security before taking out a loan, advised Gardner and Titus.

“Job security is important, absolutely. What is your contingency plan in the event you become unemployed? How are you going to pay the taxes?” said Gardner.

If a 401(k) loan is used for a down payment, don’t make the mistake of buying a bigger house than your monthly income can handle for a mortgage, he said.

Continue to make regular contributions to your retirement plan provided you can manage both the loan payments and contributions.

“You cannot stop saving toward retirement just because you bought a house,” said Gardner.

WHEN NOT TO DO IT

It’s probably not wise to take out a 401(k) plan loan when:

 • You plan to leave your job in the next couple of years.

 • There’s a chance you will lose your job due to a company restructuring.

 • You are nearing retirement.

 • You can obtain the funds from other sources.

 • You can’t continue to make regular contributions to your plan.

 • You can’t pay off the loan right away if you are laid off or change jobs.

 • You need the loan to meet everyday living expenses.

 • You want the money to purchase some luxury item or pay for a vacation.