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Hi,
Me and my husband are doing the same thing. You don't have to start that until you are under contract of your home. Either way your LO will ask for sources of your downpayment and you will have to provide the statement from your 401k.
1st:
Start looking into your 401k plan provisions for allowing this and take a look at the application for a head's up what you need to do
2nd:
Yes do let your lender know, but also how it typically works I've read is that you wait until you are under contract for a home (i.e. you and seller agree on a price and terms and everyone signs), then at this time you initiate the 401k loan.
I would advise to botrrow a 2nd loan if that is your plan when you are under a home contract so as to not pay interest right away; your lender will likely advise the same
If your question is if you should pay off the current loan first, you may want to since the lender may take your current payments (shown on your pay stub) as part of DTI.
My understanding is that the 401k "loan" is secured by the funds left in the account. These funds left in your account are therefore not available to be counted as reserves or otherwise available as assets. Since the "loan" is really your own money, if you fail to repay it no one is going to sue you for it and therefore are NOT counted towards your DTI.
It will not count against your DTI.