Why You Should Use a Roth IRA for Your Down Payment (+pros and cons)

The excitement of buying your first home can be drastically stripped from you when realizing just how many “hidden” costs you have to pay. The down payment alone can be a whopping 20% of the home price! 

Of course, you can always dip into your Roth IRA to cover these costs. But is it a good idea, financially speaking? Or do the drawbacks outweigh the benefits? Here’s what you need to know…

What you Need to Know About IRA Withdrawal

If you have a large amount of money in a Roth IRA, it’s tempting to use it as a down payment on your first home. But there are several taxes and penalties you may face, depending on your situation.

There are two types of Roth IRA contribution categories: the contributions, and the investment return on those contributions. Basically, there’s the original sum you deposited, and the interest you’ve made on that sum. If you’re trying to finance a home purchase, this distinction ends up being very important. Here’s how:

• Contributions: You are free to withdraw the original contributions made to your Roth IRA at any time. There is no tax penalty regardless of when you withdraw the distribution. 
• Investment earnings (made at least five years ago). You are free to withdraw investment earnings up to $10,000, penalty-free, toward the purchase of your first home. A first-time homebuyer is considered a person who has not owned a home in the past two years. On a side note, you can use this money toward the first purchase of a home for a child, grandchild, or your parents. 
• Investment earnings (made less than five years ago). You can withdraw up to $10,000 of your investment earnings to put toward the purchase of your first home purchase, but you will have to pay income taxes. However, you won’t need to pay the early distribution penalty. Additionally, you are free to use these funds for the first home purchase of a child, grandchild or your parents. 

If you are purchasing the home with a partner, you can each pull up to $10,000 to use toward the purchase. For example, let’s say that the purchase price of the home is $200,000. You need funds to cover small down payments and closing costs. You can each pull $10,000, for a total of $20,000, which covers those costs. 

There is a lifetime cap on the $10,000 withdrawal. For example, you can only withdraw these funds one time over the life of the account. Additionally, the funds must be used within 120 days of when you pull them. 

Using IRA Funds: The Good, the Bad, and the Ugly

Withdrawing funds early from your Roth IRA helps you make a larger down payment upfront. This means you have to borrow less money to finance the rest of your home costs. Your monthly payments stay lower, and the overall interest you pay over the life of the loan is significantly smaller.

Pulling on your IRA funds can also help you avoid private mortgage insurance (PMI). This type of insurance is designed to protect the lender financially should you stop making mortgage payments. It costs around 0.5% to 1% of the home purchase price and can add hundreds of dollars to your monthly mortgage payment, depending on the amount financed. If you make a down payment of 20% or more on your first home purchase, you probably won’t have to deal with PMI. That’s a big long-term benefit.

So what are the drawbacks of drawing on your Roth IRA? The major issue is that you’re essentially raiding your own savings. Early withdrawals deprive you of the magic of long-term, compounding interest – which is the whole point of an IRA!

You’ll want to consider the current interest rate environment and stock market projections. Most advisors suggest forecasting a 6% to 7% return on retirement accounts, like your Roth IRA. In a low-interest-rate environment, you might be at an advantage borrowing more and making a smaller down payment. Even if that means your monthly mortgage payment is larger, it could break in your favor.

Other Options for Using

If you’re not sure about tapping into your Roth IRA, consider the low down-payment loans and grants available. Many of these programs allow you to borrow the down payment at 0% interest or come in the form of a grant, which you don’t need to pay back. Here are a few options to explore:

Down-payment assistance programs: Most states have first-time homebuyer down payment assistance programs available. These programs come in a variety of forms, including grants, deferred loans, and low-interest loans. 

Grants are essentially free money. There is no repayment requirement. Tax-deferred loans allow for a low interest rate and no prepayment requirement until you sell or refinance the loan. Low-interest loans allow you to cover the down payment but spread those payments out over a longer period of time, such as 10 years, to keep the upfront costs low. 

FHA loans: FHA loans (Federal Housing Administration loans) are backed by the federal government and have a low down-payment requirement and flexible credit score rules. If your credit score is over 580, you may be able to take advantage of a down-payment requirement of 3.5%. A credit score below 580 may have a down-payment requirement up to 10%. Depending on your state’s rules, you may be able to combine this program with down-payment assistance to get most of your costs covered. 

USDA loans: These loans – backed by the U.S. Department of Agriculture – are available to borrowers who meet certain income restrictions and are purchasing a property in a qualifying location (typically with a population of 20,000 or less). There is no down-payment requirement, and credit requirements are flexible. 

VA loans: If you are an active service member, veteran, or a qualifying spouse, you may be able to secure a VA loan (backed by the VA – the U.S. Department of Veterans Affairs). This type of loan allows you to take advantage of no down-payment requirement, no PMI requirement, and flexible credit score rules. 

The Bottom Line on Using Roth IRA Funds for a Down Payment

Ultimately, there’s no one-size-fits-all answer to this question. For some people, using Roth IRA funds can be a smart financial play – it keeps down their mortgage size and total interest paid while evading unnecessary costs like PMI. For others, it makes far more sense to keep their money earning interest at 6-7% in a Roth IRA, and simply secure a larger home loan at a low-interest rate.

Purchasing a home is a major decision – and a complex one! So keep studying the options available to you, brush up on home financing basics, and find the combination of programs that best meets your unique needs. The more effort you put into research, the more money you’ll save in the long run to finance your dream home.