We are a couple in our 30s with a 5-year-old son and a baby daughter. We plan to send them to public school, but we hope to help pay for their college someday. Together, we have $125,000 in annual income, $10,000 in savings, and $40,000 in a 401(k). We have two cars, with a $15,000 loan on each, as well as $4,000 in credit-card debt. We have $40,000 in equity in our current home, but we want to buy a $300,000 house with a nice backyard. Should we withdraw money from the 401(k) so we can make a 20 percent down payment?
Congratulations on the growing family. And welcome to the world of financial multitasking. You want to buy a better house, send the kids to college, and be able to retire comfortably. That's a lot of priorities. Right now I think you should focus on the house. Let's get your family into the big backyard. Then you can concentrate on the college funds.
The quick answer is that it would be smart for you to put 20 percent down on your new home. That would keep the payments affordable, avoiding the added cost of private mortgage insurance. On that $300,000 house you want, a 20 percent down payment comes to $60,000. You're about $10,000 short, given that you have $40,000 in equity and $10,000 in savings.
But I don't want you to touch the 401(k). If you did, you'd be stuck paying income tax on the money you withdraw as well as a 10 percent penalty since you're younger than 55. So you'd have to take out almost $18,000 just to keep $10,000. That's a really bad idea. You could arrange a loan from the 401(k), but I'm not a fan of that option, either. First, the money you invested in the 401(k) was pretax, but if you were to take out a loan you'd repay it with after-tax money. Then, 20 or 30 years down the line when you start making withdrawals as a retiree, that money would be taxed again. And what if you get fired or become ill and can't work? Did you know that a 401(k) loan has to be repaid within a few months of leaving your job? Can you imagine paying off that loan without another job? Yikes. What's more, the real cost of taking a loan on your 401(k) is that your money won't be invested in the stock market. Last year, you might have missed out on gains that topped 25 percent.
So let's work on boosting your savings. With your income, you should have saved more than $10,000 by now. And you have way too much debt. I'd like you to do everything you can to pay down your credit-card interest and car loans. Make it a priority to save more and spend less.
When the debts are paid off, take the money you were paying toward them each month and put it in a new savings account. Call it your Trade-Up Down Payment Fund. I also want you to boost your down-payment savings by suspending your 401(k) contributions after you have enough to get the maximum employer match. Then take the money that would have gone into your 401(k) and instead put it in your down-payment fund. (Remember to "rejoin" the 401(k) at the end of each year so you'll be in a position to get the company match when the next year begins. Then simply stop again once you max out. Repeat as long as necessary.) Within a year or so, you should have all the money you need to get your family that backyard.
Oh, by the way, paying off all your debt should increase your credit score, which lenders check before issuing a mortgage. The higher the score, the lower the interest rate you are likely to pay.
From the Spring 2004 issue of O, The Oprah Magazine
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