In the current economic downturn, financially stressed homeowners are becoming increasing desperate to do what they can to avoid foreclosure. At the same time, others whose finances are secure may be looking at falling home prices and historically low interest rates and thinking that now would be a good time to buy their first home, if they could only put up enough for the down payment.

Both may be looking at their 401K piggy bank and pondering whether it's time to get out the hammer.

Law allows for hardship withdrawals

It's a decision that has to be approached very carefully, in either case. The law establishing 401K accounts was specifically written to allow for hardship withdrawals prior to retirement - and most would consider a pending foreclosure a definite hardship. The law also allows for withdrawals in certain other circumstances, including the purchase of a new home.

Proceed with caution

Most financial advisers recommend against raiding a 401K except in extreme circumstances, for a variety of reasons. First, withdrawals are subject to a 10 percent early withdrawal penalty if taken before age 59.5, and are taxed as ordinary income as well. Second, you're losing the compound earnings you would gain over time and will likely need when retirement rolls around. Also, 401Ks are protected in the event of a bankruptcy, so you'd be taking money out of a protected asset and putting it into one where it would be exposed to possible loss.

Consider a loan

A better option may be to take a loan against your 401K, if your employer allows it. This means you're essentially borrowing the money from yourself. The loan does have to be paid back into your 401K, with interest, but the rates are typically low and you don't get hit with an early withdrawal fee or income tax on the amount borrowed.

At the same time, borrowing against your 401K brings its own set of problems. Those who are unemployed typically can't borrow against their 401Ks. If you're working and leave your employer, you'll probably have to repay the remaining balance almost immediately, typically within 60-90 days. Also, for those seeking to buy a home, the loan from your 401K would be included among your debt obligations, so it could actually end up making the mortgage more difficult to obtain.

Good money after bad?

For those facing foreclosure, a critical issue is the actual value of their home - most financial advisers would strongly advise against tapping a 401K to maintain payments on a $200,000 mortgage for a home whose market value has slipped to $150,000. However, for those with a significant equity stake in their home, it may make sense to tap the account to preserve the capital already tied up in the home. In all cases, it is essential to talk with a financial adviser before taking any action.

Consult your financial adviser

For those thinking of buying a home, borrowing against a 401K could make it easier to obtain a mortgage and avoid paying mortgage insurance, while taking advantage of the current low interest rates and home prices. However, remember that your 401K has also probably taken a hit in the current downturn, so you're borrowing against devalued securities - what you gain in lower interest rates and house prices needs to be considered against potential gains when the market recovers. Again, consult with a financial advisor before making any moves.

Published on August 22, 2013