Should I use money from my retirement account to pay down credit card debt before I apply for a mortgage?

By Harry Jensen, Trusted Mortgage Expert with 45+ Years of Experience

Edited by Michael Jensen, Mortgage and Finance Guru

Updated October 20, 2020

The answer to your question depends on your financial priorities and what price home you want to buy. Paying down your monthly debt increases the mortgage you qualify for but you can also use funds from your retirement account for the down payment on a home, penalty-free. We review these scenarios below to help you understand the option that is right for you.

Paying down your credit card balance reduces your monthly debt expense which lowers your debt-to-income ratio. In short, the lower your monthly debt payments for credit cards as well as car, student and personal loans, the higher the mortgage amount you can afford.

Reducing your credit card balance may also improve your credit score, which enables you to qualify for better mortgage terms including a lower interest rate and fees. So using money from your retirement account to pay off or down your credit card account should boost the mortgage you qualify for and enable you to buy a higher priced home.

Additionally, when you apply for a mortgage you do not typically get any credit for your retirement account savings. Specifically, having significant retirement funds does not allow you to afford a higher mortgage amount by itself or meet potential reserve requirements.

The table below shows mortgage rates and fees for leading lenders in your area.  We recommend that you contact multiple lenders to understand how paying down your credit card balance impacts the mortgage you qualify for.  Shopping multiple lenders also enables you to find the best loan terms. 

If your retirement funds do not directly help you qualify for a mortgage, then why not use them to pay down debt and improve your debt-to-income ratio? The answer is that it is not that simple and there are multiple factors to consider.

Withdrawing money from a retirement account usually involves a penalty which means you are handing money to the government, which is not ideal. The penalty for taking money out of your retirement account early varies depending on the type of account and other factors but is usually 10% of the withdrawal.

For example, if you take $10,000 out of your account to pay off credit card debt, you may be required to pay a $1,000 penalty. When you evaluate different financing options you should think of the penalty as an additional closing cost you are required to pay to buy a home.

Another factor to consider is that you want to have sufficient funds in your retirement account when you retire. This is less of an issue if retirement is a ways off for you, but if you are planning to retire in the near future then this is an important consideration.

If you deplete your account to buy a home, it may take time to rebuild your retirement funds. In a worst case scenario, you may have to delay your retirement. So it is important to understand the trade off between paying penalty to afford a higher mortgage amount today and potentially not having enough money available when you retire.

An alternative method of tapping your retirement account to buy a home is to use the funds for your down payment instead of paying off debt. You can use up to $10,000 -- $20,000 if you are married -- in retirement funds to buy a home, including to pay for your down payment, closing costs or property renovations, without incurring a penalty, making it a potentially more cost-effective financing alternative.

Please note that you are required to be a first-time home buyer to qualify for the retirement account withdrawal exception although the definition of first-time home buyer is relatively flexible. As long as you have not owned your primary residence within the past two years, you are a first-time home buyer.

Review How to Use Money from a Retirement Account to Buy a Home

Because you can access a certain amount of your retirement funds penalty-free to buy a home, it may make more financial sense to use the funds to pay for all or part of your down payment, which may allow you to afford more house. For example, if you can afford a $350,000 home without using money from your retirement account, you may be able to buy a $370,000 home if you use the $20,000 first-time home buyer exception (assuming you are married).

The best way to decide if you should use retirement account funds to pay down your credit card balance or directly toward the purchase price of a home is to compare the two options. If paying down your credit card enables you to afford more than a $20,000 increase in home price ($10,000 if you are single) -- because you can afford a higher mortgage amount -- then that is the better way to deploy your retirement funds.

If paying down or off your credit card balance does not increase the price of the home you can afford by at least $20,000 ($10,000 if you are single), then it is better to use the funds directly to buy the home, likely by making a higher down payment

Use ourHOW MUCH HOME CAN I AFFORD CALCULATORto compare what price home you can buy with different down payments and monthly debt expense

Finally, we highly recommend that you consult a tax specialist to review the tax consequences of withdrawing money from a retirement account. It is important to understand the financial impact of accessing your retirement account to help you qualify for a mortgage or to buy a home, including any penalties you may be required to pay.

Sources

"Topic No. 557 Additional Tax on Early Distributions from Traditional and Roth IRAs."  IRS.  Internal Revenue Service, February 13 2020.  Web.