Jul
17
2025
Interest Rate Options, Explained

Interest Rate Options, Explained

By | Growing Wealth, invest, Investing, Terminology | Comments Off on Interest Rate Options, Explained

Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.

Interest rate options are derivatives that let traders speculate on or hedge against interest rate fluctuations. These contracts are tied to benchmarks like U.S. Treasuries or Eurodollars, and are primarily used by institutions that manage rate exposure. These options are structured as calls and puts, and can be used to express a view on how yields might change over time.

This guide breaks down how interest rate options work, including key terms, common use cases, and the potential risks involved.

Key Points

•   Interest rate options are financial instruments for speculating on or hedging against interest rate movements.

•   These options are structured as calls and puts, linked to benchmarks such as U.S. Treasuries.

•   Buyers of calls may potentially profit when interest rates rise, while the buyers of puts may benefit from falling rates.

•   Interest rate options are settled in cash, with the maximum loss for the buyer limited to the premium paid.

•   Trading these options involves significant market and interest rate risks, especially if the buyer misjudges rate direction, timing, or volatility.

What Are Interest Rate Options?

Interest rate options enable investors to hedge, speculate on, or otherwise help manage their exposure to interest rates. These financial derivatives are available as both puts and calls, and are traded on major options exchanges. They can also be used to secure exposure to a specific interest rate level over a set time frame. Interest rate options offer buyers the right to profit from a known rate level at expiration, often as a hedge against rising or falling yields. This cap may help secure more predictable outcomes in a volatile rate environment.

Interest rates in the U.S. fluctuate continuously, with the Federal Reserve being a key driver, among other factors. To mitigate the risk that interest rate fluctuations could erode portfolio value, and to potentially benefit from rate changes, professional money managers turn to interest rate options as a source for managing exposure.

Interest rate options are sold on major options exchanges as standardized puts and calls — the two primary types of option contracts. Similar to puts and calls on equity securities, interest rate options represent directional bets on the value of an underlying asset.

The value of interest rate options is tied to yields on interest-rate-linked assets, typically Eurodollars and U.S. Treasuries of various maturities. These options are cash-settled and typically do not involve the delivery of a bond. Instead, buyers receive a payout if the reference rate moves in their favor.

Buyers of interest rate options can gain exposure to a specific interest rate over a defined term. Treasury maturities are standardized terms commonly sold on the CME Group exchanges. These products are used primarily by institutional investors and sophisticated traders managing large portfolios or interest rate exposure. Professional money managers may use puts or calls at any given maturity to express their views on future rate movements or the volatility of borrowing costs over time.

For example, a fund manager concerned about rising borrowing costs could purchase a call option tied to the 5-year Treasury as a hedge. If rates rise, the option gains value. This could potentially offset higher financing expenses or losses elsewhere in the manager’s portfolio.

How Interest Rate Options Work

Interest rate options afford the buyer the right to receive payment based on the spread between the yield of the underlying security on the expiration date and the original strike rate of the option, net of fees.

Interest rate options in the United States feature “European-style” options exercise terms, which means they can only be exercised on the expiration date.

This contrasts with equity options, which more often contain “American-style” exercise terms. That means they can be exercised at any time before and on the expiration date.

Buyers of interest rate options pay a premium — the price of the options contract — to acquire the right to receive a cash settlement if interest rates move in their favor. Options pricing can be complex, and to profit on a trade, the buyer needs interest rates to move in their favor enough to cover the cost of the option’s premium.

In the event that interest rates don’t move in the option holder’s favor enough to overcome the strike rate, the option will expire worthless, and the option holder incurs the total loss of their premium.

We’ll cover how this dynamic plays out with respect to both interest rate calls and puts.

How Do Interest Rate Call Options Work

Buyers of interest rate call options seek to benefit from rising interest rates. Should the yield on the underlying security close above its strike rate on the expiration date, the owner of an interest rate call option will receive a cash payout. This payout will be the difference between the option value at maturity and its strike.

Note that interest rate options are cash-settled. Unlike equity options, no exercise is required. If the rate is higher than the strike rate, the holder is paid the difference.

Interest rate call options, much like equity call options, give the buyer potential upside exposure to rising yields. They can also offer a way to effectively “lock in” an interest rate level for potential payout calculation, which benefits the buyer if rates rise above the strike.

Holders of interest rate call options bear the risk that the option might expire out-of-the-money should interest rates remain beneath the strike by the expiration date. In this case, the maximum loss the owner of an interest rate call option can expect is limited to the premium paid.

How Do Interest Rate Put Options Work

In contrast, buyers of interest rate put options seek to benefit from falling interest rates. Interest rate puts give the put holder the right to receive payment based on the difference between the strike rate and the yield on the underlying security at expiration. Since the payout depends on the yield falling below the strike rate, the buyer effectively locks in the right to receive a higher interest rate (rather than pay a lower one) for a fixed period, compared to market rates at expiration. In this case, the strike rate is typically the maximum gain that a put holder may receive.

Holders of interest rate put options bear the risk that the put option might expire worthless (out-of-the-money) if interest rates rise above the strike by the expiration date. In this case, the maximum loss the buyer of an interest rate put option will incur is limited to the premium paid.

What Are the Risks of Trading Interest Rate Options?

Trading interest rate options may involve significant risk, particularly for any trader who either, 1) lacks understanding of the basic drivers of options valuation and interest rates, or 2) doesn’t know how to structure their options trade properly to manage risk exposure. The leverage associated with options trades can result in significant losses if not managed carefully. Since these contracts define a rate level at the outset, traders risk loss if actual market rates move unexpectedly in the opposite direction.

Traders must manage a range of key risks and may want to consider different strategies for trading options, when it comes to buying interest rate puts and calls. Risks related to interest rate options include “market risk,” or the risk of price movements driven by macroeconomic factors that affect financial markets. It also includes “interest rate risk,” or the possibility that changes in interest rates could erode the value of fixed-income holdings, especially when those shifts are abrupt or unexpected. Traders may also face losses if they misjudge rate direction, timing, volatility, or fail to anticipate how quickly investors might adjust their outlook based on new interest rate information.

Interest Rate Option Example

For example, an investor seeking to hedge their portfolio against rising interest rates may choose to buy an interest rate call option on a 10-year Treasury bond, expiring in two months at a strike of $50.00.

Strikes on interest rate options reflect a rate that’s multiplied by 10 and expressed in dollar terms to standardize pricing. Therefore a 5.0% rate converts to a strike price of $50.

If the option’s premium is quoted at $0.50, then buying a single interest rate call option would cost the buyer a $50 total premium, as each interest rate option affords the buyer exposure to 100 shares of the underlying interest rate.

If yields rise for the next 2 months until the option expires, the underlying might be worth $55 by the time it’s exercised.

In this instance, you can calculate your net profit using the following equation:

(Reference Rate at Expiry – Strike Rate) x 100 – Premium Paid = Profit

($55 – $50) X 100 ) – $50 = Profit

$5 X 100 – $50 = Profit

$500 – $50 = $450 Net Profit

Remember that each option contract grants exposure to 100 units of the underlying interest rate, while options premiums are quoted for a single unit of the underlying. Remember also to use the full contract premium and apply a multiplier of 100 when calculating net profit.

The Takeaway

Interest rate options may appeal to investors who understand the underlying drivers of these securities. They provide direct exposure to interest rates, on a leveraged basis, at a relatively competitive cost.

When employed strategically, interest rate options may allow investors to profit from changes in interest rates or help mitigate their downside in a volatile rate environment.

SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.

With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.

Explore SoFi’s user-friendly options trading platform.

🛈 SoFi does not offer interest rate options trading at this time.

FAQ

What are interest rate future options?

Interest rate future options are futures contracts tied to an underlying interest-bearing security. The buyer purchases the right to receive the interest rate payment in the contract, while the seller agrees to pay it.

These options allow both parties to lock in the price on an interest-bearing security, for future delivery, which offers both parties some level of price certainty within a specific timeframe.

What is an interest rate swaption?

Interest rate swaptions represent the right, but not the obligation, to enter into an interest rate swap on an agreed-upon date.

In exchange for the contract premium, the buyer of an interest rate swaption can choose whether to be a fixed-rate payer (payer swaption), or fixed-rate receiver (receiver swaption) on the underlying swap, with the counterparty taking the variable rate side of the transaction.

Unlike standard interest rate options, swaptions are over-the-counter products, allowing for more customized terms across expiration, exercise style, and notional amount.

What is interest rate risk?

Interest rate risk is the exposure of an investment to fluctuations in prevailing rates. Rates can change daily, based on economic growth, monetary policies set by central banks, or investor sentiment.

If interest rates rise, that shift may reduce the value of bonds and other fixed-income assets. Conversely, if rates fall, the value of outstanding fixed-income securities often rises. This kind of exposure defines interest rate risk.

Photo credit: iStock/LaylaBird

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.

For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SOIN-Q225-072

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Jul
16
2025
IRA Withdrawal Rules: All You Need to Know

Traditional and Roth IRA Withdrawal Rules & Penalties

By | invest, Investing, Preparing for Retirement | Comments Off on Traditional and Roth IRA Withdrawal Rules & Penalties

The purpose of an Individual Retirement Account (IRA) is to save for retirement. Ideally, you sock away money consistently in an IRA and your investment grows over time.

However, IRAs have strict withdrawal rules both before and after retirement. It’s very important to understand the IRA rules for withdrawals to avoid incurring penalties.

Here’s what you need to know about IRA withdrawal rules.

Key Points

  • Traditional and Roth IRAs have specific withdrawal rules and penalties.
  • Roth IRA withdrawal rules include the five-year rule for penalty-free withdrawals of earnings, and required minimum distributions (RMDs) for inherited IRAs. You can always withdraw your Roth IRA contributions tax-free and penalty-free.
  • Traditional IRA withdrawals before age 59 ½ incur regular income taxes and a 10% penalty on the taxable portion.
  • There are exceptions to the penalty, such as using funds for unreimbursed medical expenses (exceeding 7.5% of AGI), health insurance premiums during unemployment, total and permanent disability, qualified higher education expenses, and first-time home purchases (up to $10,000 lifetime limit).
  • Generally speaking, early IRA withdrawals might be thought of as a last resort due to the potential impact on retirement savings and tax implications, including lost opportunity for growth.

Roth IRA Withdrawal Rules

So when can you withdraw from a Roth IRA? The IRA withdrawal rules are different for Roth IRAs vs traditional IRAs. For instance, qualified withdrawals from a Roth IRA are tax-free, since you make contributions to the account with after-tax funds.

There are some other Roth IRA withdrawal rules to keep in mind as well.[1]

The Five-year Rule

The date you open a Roth IRA and how long the account has been open is a factor in taking your withdrawals.

According to the five-year rule, you can generally withdraw your earnings tax- and penalty-free if you’re at least 59 ½ years old and it’s been at least five years since you opened the Roth IRA. You can withdraw contributions to a Roth IRA anytime without taxes or penalties. (The annual IRA contribution limits for 2024 and 2025 are $7,000, or $8,000 for those age 50 and up.)

Even if you’re 59 ½ or older, you may face a Roth IRA early withdrawal penalty if the retirement account has been open for less than five years when you withdraw earnings from it.

These Roth IRA withdrawal rules also apply to the earnings in a Roth that was a rollover IRA. If you roll over money from a traditional IRA to a Roth and you then make a withdrawal of earnings from the Roth IRA before you’ve owned it for at least five years, you’ll owe a 10% penalty on the earnings.

For inherited Roth IRAs, the five-year rule applies to the age of the account. If your benefactor opened the account more than five years ago, you can withdraw earnings penalty-free. If you tap into the money before that, though, you’ll owe taxes on the earnings.

Required Minimum Distributions (RMDs) on Inherited Roth IRAs

In most cases, you do not have to pay required minimum distributions (RMDs) on money in a Roth IRA account.

However, according to the SECURE Act, if your loved one passed away in 2020 or later, you don’t have to take RMDs, but you do need to withdraw the entire amount in the Roth IRA within 10 years.[2]

There are two ways to do that without penalty:

  • Withdraw funds by December 31 of the fifth year after the original holder died. You can do this in either partial distributions or a lump sum. If the account is not emptied by that date, you could owe a 50% penalty on whatever is left.
  • Take withdrawals each year, based on your life expectancy.

Tax Implications of Roth IRA Withdrawals

Contributions to a Roth IRA can be withdrawn any time without taxes or penalties. However, let’s say an individual did active investing through their account, which generated earnings. Any earnings withdrawn from a Roth before age 59 ½ are subject to a 10% penalty and income taxes.

Recommended: Retirement Planning Guide

Traditional IRA Withdrawal Rules

If you take funds out of a traditional IRA before you turn 59 ½, you’ll owe regular income taxes on the contributions and the earnings, per IRA tax deduction rules, plus a 10% penalty. Brian Walsh, CFP® at SoFi specifies, “When you make contributions to a traditional retirement account, that money is going to grow without paying any taxes. But when you take that money out — say 30 or 40 years from now — you’re going to pay taxes on all of the money you take out.”

RMDs on a Traditional IRA

The rules for withdrawing from an IRA mean that required minimum distributions kick in the year you turn 73 (as long as you turned 72 after December 31, 2022). After that, you have to take distributions each year, based on your life expectancy. If you don’t take the RMD, you’ll owe a 25% penalty on the amount that you did not withdraw. The penalty may be lowered to 10% if you correct the mistake and take the RMD within two years.[3]

Early Withdrawal Penalties for Traditional IRAs

In general, an early withdrawal from a traditional IRA before the account holder is at least age 59 ½ is subject to a 10% penalty and ordinary income taxes.[4] However, there are some exceptions to this rule.

Recommended: What Is a SEP IRA?

When Can You Withdraw from an IRA Without Penalties?

As noted, you can make withdrawals from an IRA once you reach age 59 ½ without penalties.

In addition, there are other situations in which you may be able to make withdrawals without having to pay a penalty. These include having medical expenses that aren’t covered by health insurance (as long as you meet certain qualifications), having a permanent disability that means you can no longer work, and paying for qualified education expenses for a child, spouse, or yourself.

Read more about these and other penalty-free exceptions below.

9 Exceptions to the 10% Early-Withdrawal Penalty on IRAs

Whether you’re withdrawing from a Roth within the first five years or you want to take money out of an IRA before you turn 59 ½, there are some exceptions to the 10% penalty on IRA withdrawals.

1. Medical Expenses

You can avoid the early withdrawal penalty if you use the funds to pay for unreimbursed medical expenses that total more than 7.5% of your adjusted gross income (AGI).

2. Health Insurance

If you’re unemployed for at least 12 weeks, IRA withdrawal rules allow you to use funds from an IRA penalty-free to pay health insurance premiums for yourself, your spouse, or your dependents.

3. Disability

If you’re totally and permanently disabled, you can withdraw IRA funds without penalty. In this case, your plan administrator may require you to provide proof of the disability before signing off on a penalty-free withdrawal.

4. Higher Education

IRA withdrawal rules allow you to use IRA funds to pay for qualified education expenses, such as tuition and books for yourself, your spouse, or your child without penalty.

5. Inherited IRAs

IRA withdrawal rules for inherited IRAs state that you don’t have to pay the 10% penalty on withdrawals from an IRA, unless you’re the sole beneficiary of a spouse’s account and roll it into your own, non-inherited IRA. In that case, the IRS treats the IRA as if it were yours from the start, meaning that early withdrawal penalties apply.

6. IRS Levy

If you owe taxes to the IRS, and the IRS levies your account for the money, you will typically not be assessed the 10% penalty.

7. Active Duty

If you’re a qualified reservist, you can take distributions without owing the 10% penalty. This goes for a military reservist or National Guard member called to active duty for at least 180 days.[5]

8. Buying a House

While you can’t take out IRA loans, you can use up to $10,000 from your traditional IRA toward the purchase of your first home — and if you’re purchasing with a spouse, that’s up to $10,000 for each of you. The IRS defines first-time homebuyers as someone who hasn’t owned a principal residence in the last two years. You can also withdraw money to help with a first home purchase for a child or your spouse’s child, grandchild, or parent.

In order to qualify for the penalty-free withdrawals, you’ll need to use the money within 120 days of the distribution.

9. Substantially Equal Periodic Payments

Another way to avoid penalties under IRA withdrawal rules is by starting a series of distributions from your IRA spread equally over your life expectancy. To make this work, you must take at least one distribution each year and you can’t alter the distribution schedule until five years have passed or you’ve reached age 59 ½, whichever is later.

The amount of the distributions must use an IRS-approved calculation that involves your life expectancy, your account balance, and interest rates.

Understanding How Exceptions Are Applied

If you believe that any of the exceptions to early IRA withdrawal penalties apply to your situation, you may need to file IRS form 5329 to claim them.[6] However, it’s wise to consult a tax professional about your specific circumstances.


💡 Quick Tip: For investors who want a diversified portfolio without having to manage it themselves, automated investing could be a solution (although robo advisors typically have more limited options and higher costs). The algorithmic design helps minimize human errors, to keep your investments allocated correctly.

Is Early IRA Withdrawal Worth It?

While there may be cases where it makes sense to take an early withdrawal, many financial professionals agree that it should be a last resort. These are disadvantages and advantages to consider.

Pros of IRA Early Withdrawal

  • If you have a major expense and there are no other options, taking an early withdrawal from an IRA could help you cover the cost.
  • An early withdrawal may help you avoid taking out a loan you would then have to repay with interest.

Cons of IRA Early Withdrawal

  • By taking money out of an IRA account early, you’re robbing your own nest egg not only of the current value of the money but also the chance for future years of compound growth.
  • Money taken out of a retirement account now can have a big impact on your financial security in the future when you retire.
  • You may owe taxes and penalties, depending on the specific situation.

Alternatives to Early IRA Withdrawal

Rather than taking an early IRA withdrawal and incurring taxes and possible penalties, as well as impacting your long-term financial goals, you may want to explore other options first, such as:

  • Using emergency savings: Building an emergency fund that you can draw from is one way to cover unplanned expenses, whether it’s car repairs or a medical bill, or to tide you over if you lose your job. Financial professionals often recommend having at least three to six months’ worth of expenses in your emergency fund.

    To create your fund, start contributing to it weekly or bi-weekly, or set up automatic transfers for a certain amount to go from your checking account into the fund every time your paycheck is direct-deposited.

  • Taking out a loan: You could consider asking a family member or friend for a loan, or even taking out a personal loan, if you can get a good interest rate and/or favorable loan terms. While you’ll need to repay a loan, you won’t be taking funds from your retirement savings. Instead, they can remain in your IRA where they can potentially continue to earn compound returns.

Opening an IRA With SoFi

IRAs are tax-advantaged accounts you can use to save for retirement. However, it is possible to take money out of an IRA if you need it before retirement age. Just remember, even if you’re able to do so without paying a penalty, the withdrawals could leave you with less money for retirement later.

Prepare for your retirement with an individual retirement account (IRA). It’s easy to get started when you open a traditional or Roth IRA with SoFi. Whether you prefer a hands-on self-directed IRA through SoFi Securities or an automated robo IRA with SoFi Wealth, you can build a portfolio to help support your long-term goals while gaining access to tax-advantaged savings strategies.

Help build your nest egg with a SoFi IRA.

FAQ

Can you withdraw money from a Roth IRA without penalty?

You can withdraw your contributions to a Roth IRA without penalty no matter what your age. However, you generally cannot withdraw the earnings on your contributions before age 59 ½, or before the account has been open for at least five years, without incurring a penalty.

What are the rules for withdrawing from a Roth IRA?

You can withdraw your own contributions to a Roth IRA at any time penalty-free. But to avoid taxes and penalties on your earnings, withdrawals from a Roth IRA must be taken after age 59 ½ and once the account has been open for at least five years.

However, there are a number of exceptions in which you typically don’t have to pay a penalty for an early withdrawal, including some medical expenses that aren’t covered by health insurance, being permanently disabled and unable to work, or if you’re on qualified active military duty.

What are the 5 year rules for Roth IRA withdrawal?

Under the 5-year rule, if you make a withdrawal from a Roth IRA that’s been open for less than five years, you’ll owe a 10% penalty on the account’s earnings. If your Roth IRA was inherited, the 5-year rule applies to the age of the account. So if you inherited the Roth IRA from a parent, for instance, and they opened the account more than five years ago, you can withdraw the funds penalty-free. If the account has been opened for less than five years, however, you’ll owe taxes on the gains.

How do inherited IRA withdrawal rules differ?

According to inherited IRA withdrawal rules, you don’t have to pay the 10% penalty on withdrawals from an IRA unless you’re the sole beneficiary of a spouse’s account and roll it into your own, non-inherited IRA. In that case, the IRS treats the IRA as if it were yours from the start, meaning that early withdrawal penalties apply.

In addition, for inherited IRAs, the five-year rule applies to the age of the account. If the person you inherited the IRA from opened the account more than five years ago, you can withdraw earnings penalty-free.

Are there penalties for missing RMDs?

Yes, there are penalties for missing RMDs. You are required to start taking RMDs when you turn 73, and then each year after that. If you miss or don’t take RMDs, you’ll typically owe a 25% penalty on the amount that you failed to withdraw. The penalty could be lowered to 10% if you correct the mistake and take the RMD within two years.

Article Sources
  1. IRS. IRA FAQs – Distributions (withdrawals).
  2. IRS. Retirement topics – Beneficiary.
  3. IRS. Retirement plan and IRA required minimum distributions FAQs.
  4. IRS. What if I withdraw money from my IRA?.
  5. U.S. Army. The HEART Act.
  6. H&R Block. When Should You Use Form 5329?.

Photo credit: iStock/Fly View Productions

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.

For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.

Brokerage and Active investing products offered through SoFi Securities LLC, member FINRA(www.finra.org)/SIPC(www.sipc.org). For all full listing of the fees associated with Sofi Invest, please view our fee schedule.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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Jul
16
2025
couple holding keys

Should You Use Your 401(k) as a First-Time Home Buyer?

By | Growing Wealth, Investing, Preparing for Retirement | Comments Off on Should You Use Your 401(k) as a First-Time Home Buyer?

There are two options if you want to use your 401(k) to buy a house and not incur a penalty: a 401(k) loan or a hardship withdrawal. These options come with many rules and restrictions — and given the potential risk to your retirement savings, it’s wise to consider some alternatives.

Among the requirements: If you borrow money from your 401(k) to buy a primary residence, you’d have to pay back that loan with interest. If you take what’s known as a hardship withdrawal for a down payment on your principal residence, you have to meet the strict IRS criteria for “immediate and heavy financial need” for doing so.

You won’t owe tax on a 401(k) loan, but it generally must be repaid within five years. A hardship withdrawal (if you qualify) still requires that you pay income tax on the withdrawal. In addition, every workplace plan is different and may have different rules.

Before you consider using your 401k to buy a home, which could permanently reduce your retirement savings, explore alternatives like withdrawing funds from a traditional or Roth IRA, seeking help from a Down Payment Assistance Program (DAP), or seeing if you qualify for other types of home loans.

Key Points

•   Many 401(k) plans allow employees to withdraw funds, but an early withdrawal, i.e., before age 59 ½ , comes with a 10% penalty (on top of income tax).

•   If your plan allows it, you may avoid the 10% penalty by taking a 401(k) loan or a hardship withdrawal (assuming you meet strict IRS requirements).

•   You don’t have to repay a hardship withdrawal, but you will owe income tax on the amount you withdraw.

•   Taking out a 401(k) loan may be easier than borrowing from a bank, but the loan typically must be repaid within five years, or you could owe tax and a penalty.

•   Before using your 401(k) to help buy a house, consider the serious impact it might have on your retirement savings.

Can You Use a 401(k) to Buy a House?

A 401(k) is generally a type of employer-sponsored retirement plan, which you may be able to manage through the plan sponsor’s website (similar to investing online).

If your employer plan allows it, you can use your 401(k) to help buy a house, and it won’t be seen as an early 401(k) withdrawal with a 10% penalty. Here’s what you need to know.

2 Ways to Use Your 401(k) to Buy a House

There are only two ways you can use a 401(k) to buy a house, penalty free. Note that the following rules generally apply to other employer-sponsored plans as well, like a 403(b) or 457(b). But all retirement plans have different rules, so be sure to check the terms.

•   401(k) loan. If your plan allows you to borrow from your 401(k) to buy a house, you’ll avoid the 10% early withdrawal penalty, and you won’t owe tax on the loan. But you must repay the loan to yourself, plus interest.

•   Hardship withdrawal. If you’re under 59 ½, you may be able to take out a hardship withdrawal without incurring a 10% penalty, but only if you meet specific IRS requirements for “an immediate and heavy financial need.”

There are several conditions that qualify as a hardship, one of them is for the purchase of a primary residence, but not a second home.

You’ll owe income tax on a hardship withdrawal, regardless of the circumstances.

How Much of Your 401(k) Can Be Used for a Home Purchase?

The amount you can take out of a 401(k) depends on the method you use.

•   401(k) loan. You can generally borrow up to 50% of your vested balance, up to $50,000, whichever amount is less. If 50% of your vested balance is less than $10,000, you may be able to borrow up to $10,000.

Note that after you open an IRA, the rules for taking a withdrawal from these individual retirement accounts are different. You cannot take a loan from an IRA, for example. But you may be able to take an early withdrawal for a first-time home purchase, which is discussed below.

•   Hardship withdrawal. The limits on hardship withdrawals can be determined by your specific plan, but these withdrawals are generally limited to the amount needed to cover the financial hardship in question, plus the necessary taxes.

Depending on plan rules, a hardship withdrawal may include your elective contributions (savings) as well as earnings on those deposits. But in some cases you’re not allowed to withdraw earnings.

First-time homebuyers can
prequalify for a SoFi mortgage loan,
with as little as 3% down.

How a 401(k) Loan Works

It’s possible to take a loan from an existing 401(k), and in some ways this option may seem easier. Chiefly, borrowing from a 401(k) doesn’t come with the same level of credit scrutiny as taking out a conventional bank loan, and interest rates can be favorable as well.

Your employer generally sets the rules for 401(k) loans, but you typically must pay back the loan, with interest, within five years. If a person leaves their job before the loan is repaid, the balance owed could be deducted from the remainder of their 401(k) funds.

You don’t owe any income tax on a 401(k) loan. But you pay yourself interest to help offset the loss of investment growth, since the funds are no longer invested in the market. (Although having a 401(k) is different than a self-directed brokerage account, because it’s typically tax deferred, you do invest your savings in different investment options.)

You can take out a 401(k) loan for a few different reasons (e.g., qualified educational expenses, medical expenses), depending on your plan’s policies. Those using a loan to purchase a residence may have more than five years to pay back the loan.

How a 401(k) Hardship Withdrawal Works

While it’s possible to withdraw funds from your 401(k) and most other employer-sponsored plans at any time, if you do so before age 59 ½ it’s considered an early withdrawal. And though you’d owe income tax on any 401(k) withdrawal, in the case of an early withdrawal, you’d also face a 10% penalty.

There are some exceptions to the 10% penalty, one of which is for a hardship withdrawal.

In the case of an “immediate and heavy financial need,” the IRS may permit a 401(k) hardship withdrawal under specific circumstances — including for the purchase of a primary residence. Hardship withdrawals do not cover mortgage payments, but using a 401(k) for a down payment may be allowed.

Generally, the allowable amount of the hardship withdrawal is determined by the circumstances, plus applicable taxes.

The IRS has strict rules about qualifying for a hardship withdrawal. If you don’t meet them, the funds you withdraw will be subject to income tax and a 10% early withdrawal penalty. And unlike a 401(k) loan, you can’t repay the amount you withdraw, so you permanently lose that chunk of your nest egg.

Pros and Cons of Using a 401(k) to Buy a House

Here are the pros and cons of using a hardship withdrawal or a 401(k) loan, at a glance:

Pros of Using a Hardship Withdrawal
Cons of Using a Hardship Withdrawal
If you qualify, a hardship withdrawal can provide quick access to funds for a home purchase in an emergency, without a penalty. A hardship withdrawal cannot be repaid, so the money you withdraw permanently depletes your nest egg.
A hardship withdrawal isn’t a loan, so it doesn’t have to be repaid. You owe ordinary income tax on the amount of the withdrawal.
If you don’t qualify for a hardship withdrawal, and you’re under 59 ½, it’s considered an early withdrawal and would be subject to income tax and a 10% penalty.
Pros of Using a 401(k) Loan
Cons of Using a 401(k) Loan
When using a 401(k) loan, individuals repay themselves, so they don’t owe interest to a bank or other institution. Because the loan lowers your account balance, your nest egg sees less growth.
You don’t pay a penalty or tax on a 401(k) loan, as long as you repay the loan as required. You must repay the loan with interest, typically within five years, or you’ll owe tax and penalties.
You don’t have to meet any credit requirements, and interest rates on 401(k) loans may be lower than for conventional loans. If a person leaves their job before the loan is repaid, the balance owed could be deducted from the remainder of their 401(k) funds. For those under 59 ½, the amount of the offset would also be considered a distribution and the borrower would likely owe taxes and a 10% penalty.
If you miss payments or default on a 401(k) loan, it will not impact your credit score. In some cases, your plan may not permit you to continue contributing to your 401(k) during the time that you’re repaying the loan — which can dramatically impact your retirement savings over time.

What Are the Rules & Penalties for Using 401(k) Funds to Buy a House?

Here’s a side-by-side look at some key differences between taking out a 401(k) loan versus taking a hardship withdrawal from a 401(k). Bear in mind that all employer-sponsored plans have their own rules, so be sure to understand the terms.

401(k) loans
401(k) withdrawals

•   May or may not be allowed by the 401(k) plan.

•   Relatively easy to obtain, no credit score required, versus conventional loans.

•   Qualified loans are penalty free and tax free, unless the borrower defaults or leaves their job before repaying the loan.

•   You must repay the loan with interest within a specified period. The interest is also considered tax deferred until you retire.

•   If the borrower doesn’t repay the loan on time, the loan is treated as a regular distribution (a.k.a. withdrawal), and subject to taxes and an early withdrawal penalty of 10%.

•   The maximum loan amount is 50% of the vested account balance, or $50,000, whichever is less. (If the vested account balance is less than $10,000, the maximum loan amount is $10,000.)

•   May or may not be allowed by the 401(k) plan.

•   Funds are relatively easy to access, assuming you meet the IRS standards for a hardship withdrawal.

•   If you meet IRS criteria, you may avoid the 10% penalty normally incurred by an early withdrawal.

•   You will owe income tax on the amount of the withdrawal.

•   Withdrawals cannot be repaid, so your account is permanently depleted.

•   With a hardship withdrawal, you can withdraw only enough to cover the immediate expense (e.g., a down payment, not mortgage payments), plus taxes to cover the withdrawal.

What Are the Alternatives to Using a 401(k) to Buy a House?

For some homebuyers, there may be other, more attractive options for securing a down payment instead of taking money out of a 401(k) to buy a house, depending on their situation. Here are a few of the alternatives.

Withdrawing Money From a Traditional or Roth IRA

Using a traditional or a Roth IRA to help buy a first home can be an alternative to borrowing from a 401(k) that might be beneficial for some home buyers, because you may be able to avoid the 10% penalty.

If you’re at least 59 ½, you can take a withdrawal from a traditional or Roth IRA without incurring a penalty. You will owe tax on money from a traditional IRA account, but not from a Roth IRA, as long as you’ve had the account for five years.

If you’re under 59 ½, you could face a 10% early withdrawal penalty. One exception is that a first-time home buyer can borrow up to $10,000 from an IRA without incurring a penalty. But the tax treatment differs according to the type of IRA.

•   Traditional IRA. A withdrawal for a first-time home purchase may be penalty free, but you will owe tax on the amount you withdraw.

•   Roth IRA. Contributions (i.e., deposits) can be withdrawn at any time, tax free. But earnings on contributions can only be withdrawn without a penalty starting at age 59 ½ or older, as long as you’ve held the Roth account for at least five years (a.k.a. the Roth five-year rule).

After the account has been open for five years, Roth IRA account holders who are buying their first home are allowed to withdraw up to $10,000 with no taxes or penalties. The $10,000 is a lifetime limit for a first-time home purchase, for both a traditional and a Roth IRA.

IRA funds can be used to help with the purchase of a first home not only for the account holders themselves, but for their children, parents, or grandchildren.

One important requirement to note is that time is of the essence when using an IRA to purchase a first home: The funds have to be used within 120 days of the withdrawal.

Low- and No-Down-Payment Home Loans

There are certain low- and no-down-payment home loans that homebuyers may qualify for that they can use instead of using a 401(k) for a first time home purchase. This could allow them to secure the down payment for a first home without tapping into their retirement savings.

•   FHA loans are insured by the Federal Housing Administration and allow home buyers to borrow with few requirements. Home buyers with a credit score lower than 580 qualify for a government loan with 10% down, and those with credit scores higher than 580 can get a loan with as little as 3.5% down.

•   Conventional 97 loans are Fannie Mae-backed mortgages that allow a loan-to-value ratio of up to 97% of the cost of the loan. In other words, the home buyer could purchase a house for $400,000 and borrow up to $388,000, leaving only a down payment requirement of 3%, or $12,000, to purchase the house.

•   VA loans are available for U.S. veterans, active duty members, and surviving spouses, and they require no down payment or monthly mortgage insurance payment. They’re provided by private lenders and banks and guaranteed by the United States Department of Veterans Affairs.

•   USDA loans are a type of home buyer assistance program offered by the U.S. Department of Agriculture to buy or possibly build a home in designated rural areas with an up-front guarantee fee and annual fee. Borrowers who qualify for USDA loans require no down payment and receive a fixed interest rate for the lifetime of the loan. Eligibility requirements are based on income, and vary by region.

Other Types of Down Payment Assistance

For home buyers who are ineligible for no-down payment loans, there are a few more alternatives instead of using 401(k) funds:

•   Down Payment Assistance (DAP) programs offer eligible borrowers financial assistance in paying the required down payment and closing costs associated with purchasing a home. They come in the form of grants and second mortgages, are available nationwide, can be interest-free, and sometimes have lower rates than the initial mortgage loan.

•   Certain mortgage lenders provide financial assistance by offering credits to cover all or some of the closing costs and down payment.

•   Gifted money from friends or family members can be used to cover a down payment or closing costs on certain home loans. As the recipient of the gift, you won’t owe taxes on the gift; the giver may have to pay a gift tax if the amount exceeds $19,000 for 2025.

Using Gift Funds for a Down Payment

By and large there are no restrictions on using gift funds — money given to you as a gift, not a loan — for a down payment on a home. The use of gift funds as part of a home buyer’s down payment has become more common, in fact. Nearly 40% of borrowers included some gift money as part of their downpayment, according to a 2023 survey by Zillow.

Gifts are allowed when applying for a conventional mortgage, as well as for Fannie Mae and FHA loans. In some cases, you may be required to provide a gift letter that documents that the money is a gift and not a loan. Again, the recipient generally doesn’t owe federal tax on a monetary gift, but the giver may owe a gift tax, depending on the amount.

How Using a 401(k) for a Home Purchase Affects Retirement Savings

Using your 401(k) money for anything but retirement has a very real down side, which is that it reduces the amount of money in your retirement account, even if that’s temporary, as it is with a 401(k) loan. As a result, you also lose out on any potential growth from your retirement investments.

With a 401(k) loan, you repay the amount of the loan with interest (and if you don’t you’ll owe taxes and penalties). Even so, you’ve depleted your account for a period of time, and, depending on the rules of your particular plan, you could be prohibited from making any contributions while you repay the loan.

The impact of a hardship withdrawal can be even more severe, because you’re not allowed to repay the amount you withdrew. So you lose a chunk of your savings, and you forgo the growth on that amount as well. In addition, some employer-sponsored plans may prohibit you from making contributions after taking a hardship withdrawal.

Impact on Long-Term Investment Growth

In other words, while there’s no 10% tax penalty for taking out a 401(k) loan or a hardship withdrawal, you do face a potential missed opportunity in that the amount you take out of the account is no longer invested in the market.

Thus, you lose out on any potential long-term investment growth — which can significantly cut into your potential retirement savings, when you think of the money you’re not earning, perhaps for many years.

The Takeaway

Generally speaking, a 401(k) can be used to buy a principal residence, either by taking out a 401(k) loan and repaying it with interest, or by making a 401(k) withdrawal (which is subject to income tax and a 10% withdrawal fee for people under age 59 ½).

If you meet the IRS criteria for a hardship withdrawal, though, you may avoid the 10% penalty, if your plan allows this option.

However, using a 401(k) for a home purchase is usually not advisable. Both qualified loans and hardship withdrawals have some potential drawbacks, including owing taxes and a penalty in some cases, and the potential to lose out on market growth on your savings. Fortunately, there are less risky options, as noted above. Making these choices depends on your financial situation and your goals, as well as your stomach for risk — especially where your future security is concerned.

Invest in what matters most to you with SoFi Active Invest. In a self-directed account provided by SoFi Securities, you can trade stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, options, and more — all while paying $0 commission on every trade. Other fees may apply. Whether you want to trade after-hours or manage your portfolio using real-time stock insights and analyst ratings, you can invest your way in SoFi's easy-to-use mobile app.

Invest with as little as $5 with a SoFi Active Investing account.

FAQ

What are the downsides of using a 401(k) to buy a house?

The main drawback of using funds from your 401(k), or any retirement account, is the potential loss of savings and investment earnings on that savings, which could substantially reduce your retirement nest egg.

When can you withdraw from a 401(k) without penalty?

If your plan permits a 401(k) loan, or if you qualify for a hardship withdrawal from your 401(k), you won’t be on the hook for a 10% penalty. But you would have to repay the loan with interest, and you would owe tax on the money taken for a hardship withdrawal.

Can you withdraw money from a 401(k) for a second house?

While it’s technically possible to withdraw money from a 401(k) for a second home, you would owe taxes and a 10% penalty on the amount you withdrew, so it’s not advisable.

How much can you take out of an individual IRA to buy a home?

You can withdraw up to $10,000 from an IRA for the purchase of a first home, but you would owe tax on that money (although you might avoid a 10% penalty).

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.

For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Third Party Trademarks: Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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What Is the Spot Market & How Does It Work?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is the Spot Market & How Does It Work?

A spot market is a market where buyers meet sellers and make an immediate exchange. In other words, delivery takes place at the same time payment is made. That can include stock exchanges, currency markets, or commodity markets.

But often when discussing spot markets, we’re talking about commodities. Commodity markets are somewhat different from the markets for stocks, bonds, mutual funds, and ETFs, all of which trade exclusively through brokerages. Because they represent a physical good, commodities have an additional market — the spot market. This market represents a place where the actual commodity gets bought and sold right away.

Key Points

  • Spot markets involve instant trades and immediate delivery.
  • Spot prices reflect real-time supply and demand.
  • Spot markets are less susceptible to manipulation.
  • OTC and centralized exchanges facilitate spot trades.
  • Futures markets are speculative, while spot markets are organic.

Spot Markets Definition

If you’re trying to define the spot markets, it may be helpful to think of it as a public financial market, and one on which assets or commodities are bought and sold. They’re also bought and sold for immediate, or quick, delivery. That is, the asset being traded changes hands on the spot.

Prices quoted on spot markets are called the spot price, accordingly.

One example of a spot market is a coin shop where an individual investor goes to buy a gold or silver coin. The prices would be determined by supply and demand. The goods would be delivered upon receipt of payment.

Understanding Spot Markets

Spot markets aren’t all that difficult to understand from a theoretical standpoint. There can be a spot market for just about anything, though they’re often discussed in relation to commodities (perhaps coffee, corn, or construction materials), and specific things like precious metals.

But again, an important part of spot market transactions is that trades take place on the spot — immediately.

Which Types of Assets Can Be Found on Spot Markets?

As noted, all sorts of assets can be found on spot markets. That ranges from food items or other consumables, construction materials, precious metals, and more. If you were, for instance, interested in investing in agriculture from the sense you wanted to trade contracts for oranges or bananas, you could likely do so on the spot market.

Some financial instruments may also be traded on spot markets, such as Treasuries or bonds.

How Spot Market Trades Are Made

In a broad sense, spot market trades occur like trades in any other market. Buyers and sellers come together, a price is determined by supply and demand, and trades are executed — usually digitally, like most things these days. In fact, a spot market may and often does operate like the stock market.

As noted, stock markets are also, in fact, spot markets, with financial securities trading hands instantly (in most cases).

What Does the Spot Price Mean?

As mentioned, the spot price simply refers to the price at which a commodity can be bought or sold in real time, or “on the spot.” This is the price an individual investor will pay for something if they want it right now without having to wait until some future date.

Because of this dynamic, spot markets are thought to reflect genuine supply and demand to a high degree.

The interplay of real supply and demand leads to constantly fluctuating spot prices. When supply tightens or demand rises, prices tend to go up, and when supply increases or demand falls, prices tend to go down.

The Significance of a Spot Market

The spot market of any asset holds special significance in terms of price discovery. It’s thought to be a more honest assessment of economic reality.

The reason is that spot markets tend to be more reliant on real buyers and sellers, and therefore should more accurately reflect current supply and demand than futures markets (which are based on speculation and can be manipulated, as recent legal cases have shown. More on this later.)

Types of Spot Markets

There’s only one type of spot market — the type where delivery of an asset takes place right away. There are two ways this can happen, however. The delivery can take place through a centralized exchange, or the trade can happen over the counter.

Over-the-counter

Over-the counter, or OTC trades, are negotiated between two parties, like the example of buying coins at a coin shop.

Market Exchanges

There are different spot markets for different commodities, and some of them work slightly differently than others.

The spot market for oil, for example, also has buyers and sellers, but a barrel of oil can’t be bought at a local shop. The same goes for some industrial metals like steel and aluminum, which are bought and sold in much higher quantities than silver and gold.

Agricultural commodities like soy, wheat, and corn also have spot markets as well as futures markets.

Spot Market vs Futures Market

One instance that makes clear the difference between a spot market and a futures market is the price of precious metals.

Gold, silver, platinum, and palladium all have their own spot markets and futures markets. When investors check the price of gold on a mainstream financial news network, they are likely going to see the COMEX futures price.

COMEX is short for the Commodity Exchange Inc., a division of the New York Mercantile Exchange. As the largest metals futures market in the world, COMEX handles most related futures contracts.

These contracts are speculatory in nature — traders are making bets on what the price of a commodity will be at some point. Contracts can be bought and sold for specific prices on specific dates.

Most of the contracts are never delivered upon, meaning they don’t involve delivery of the actual underlying commodity, such as gold or silver. Instead, what gets exchanged is a contract or agreement allowing for the potential delivery of a certain amount of metal for a certain price on a certain date.

For the most part, futures trading only has two purposes: hedging bets and speculating for profits. Sophisticated traders sometimes use futures to hedge their bets, meaning they purchase futures that will wind up minimizing their losses in another bet if it doesn’t go their way. And investors of all experience levels can use futures to try to profit from future price action of an asset. Predicting the exact price of something in the future can be difficult and carries high risk.

The spot market works in a different manner entirely. There are no contracts to buy or sell and no future prices to consider. The market is simply determined by what one party is willing to purchase something for.

Spot Market vs Futures Market
Spot Market

 Futures Market
No contracts to buy or sell Contracts are bought and sold outlining future prices
Trades occur instantly Trades may never actually occur at all
Non-speculative Speculative by nature

Another important concept to understand is contango and backwardation, which are ways to characterize the state of futures markets based on the relationship between spot and future prices. Some background knowledge on those concepts can help guide your investing strategy.

Note, too, that some investors may be confused by the concepts of margin trading and futures contracts. Margin and futures are two different concepts, and don’t necessarily overlap.


💡 Quick Tip: Distributing your money across a range of assets — also known as diversification — can be beneficial for long-term investors. When you put your eggs in many baskets, it may be beneficial if a single asset class goes down.

Example of a Spot Market

Consider the spot and futures markets for precious metals.

Precious-metal prices that investors see on financial news networks will most often be the current futures price as determined by COMEX. This market price is easy to quote. It’s the sum of all futures trading happening on one central exchange or just a few central exchanges.

The spot market is more difficult to pin down. In this case, the spot market could be generally referred to as the average price that a person would be willing to pay for a single ounce of gold or silver, not including any premiums charged by sellers.

Sometimes there is a difference between prices in the futures market and spot market. The difference is referred to as the “spread.” Under ordinary circumstances, the difference will be modest. During times of uncertainty, though, the spread can become extreme.

Futures Market Manipulation

As for trying to define what spot price means, it’s important to include one final note on futures markets. This will illustrate a key difference between the two markets.

Recent high-profile cases brought by government enforcement agencies like the Securities and Exchange Commission and Commodities and Futures Trading Commission highlight the susceptibility of futures markets to manipulation.

Some large financial institutions have been convicted of engaging in practices that artificially influence the price of futures contracts. Again, we can turn to the precious-metals markets for an example.

During the third quarter of 2020, JP Morgan was fined $920 million for “spoofing” trades and market manipulation in the precious metals and U.S. Treasury futures markets. Spoofing involves creating large numbers of buy or sell orders with no intention of fulfilling the orders.[1]

Because order book information is publicly available, traders can see these orders, and may act on the perception that big buying or selling pressure is coming down the pike. If many sell orders are on the books, traders may sell, hoping to get ahead of the trade before prices fall. If many buy orders are on the books, traders may buy, thinking the price is going to rise soon.

Cases like this show that futures markets can be heavily influenced by market participants with the means to do so.

Spot markets, on the other hand, are much more organic and more difficult to manipulate.

3 Tips for Spot Market Investing

For those interested in trying their hand in the spot market, here are a few things to keep in mind.

1. Know What’s Going On

Often, prices in the spot market can change or be volatile in relation to the news or other current events. For that reason, it’s important that investors know what’s happening in the world, and use that to assess what’s happening with prices for a given asset or commodity.

2. Keep Your Emotions in Check

Emotional investing or trading is a good way to get yourself into financial trouble, be it in the spot market, or any other type of trading or investing. You’d likely do well to keep your emotions in check when trading or investing on the spot market, as a result.

3. Understand the Market

It’s also a good idea to do some homework and make a solid attempt at trying to understand the market you’re trading in. There may be jargon to learn, terms to understand, price discovery mechanisms that could otherwise be foreign to even a seasoned investor — do your best to do your due diligence.

The Takeaway

Spot markets are where commodities are traded, instantly. There are numerous types of spot markets, and there are numerous types of commodities that might be traded on them. Investors would be wise to know the basics of how they work, and come armed with a bit of background knowledge about the given commodity they’re trading, in order to reach their goals.

Spot market trading can be a part of an overall trading strategy, but again, investors should know the ropes a bit before getting in over their heads. It may be a good idea to speak with a financial professional before investing.

Invest in what matters most to you with SoFi Active Invest. In a self-directed account provided by SoFi Securities, you can trade stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, options, and more — all while paying $0 commission on every trade. Other fees may apply. Whether you want to trade after-hours or manage your portfolio using real-time stock insights and analyst ratings, you can invest your way in SoFi's easy-to-use mobile app.

Opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.¹

FAQ

What is spot market vs a futures market?

Trades on a spot market occur instantly, on the spot. Trades in the futures market involve contracts for commodities with prices outlined for some time in the future — if they occur at all.

What does spot market mean?

The term spot market refers to a financial market where assets or commodities are bought and sold by traders. The trades occur on the spot, or instantly, for immediate delivery.

What is the difference between spot market and forward market?

Forward markets involve trading of futures contracts, or transactions that take place at some point in the future, whereas spot market trades occur instantly, often for cash.

Article Sources
  1. Commodity Trading Futures Commission. CFTC Orders JPMorgan to Pay Record $920 Million for Spoofing and Manipulation.

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.

For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.

An investor should consider the investment objectives, risks, charges, and expenses of the Fund carefully before investing. This and other important information are contained in the Fund’s prospectus. For a current prospectus, please click the Prospectus link on the Fund’s respective page. The prospectus should be read carefully prior to investing.
Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. Alternative investments often employ leveraging and other speculative practices that increase an investor's risk of loss to include complete loss of investment, often charge high fees, and can be highly illiquid and volatile. Alternative investments may lack diversification, involve complex tax structures and have delays in reporting important tax information. Registered and unregistered alternative investments are not subject to the same regulatory requirements as mutual funds.
Please note that Interval Funds are illiquid instruments, hence the ability to trade on your timeline may be restricted. Investors should review the fee schedule for Interval Funds via the prospectus.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by emailing customer service at [email protected]. Please read the prospectus carefully prior to investing.

Mutual Funds (MFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or clicking the prospectus link on the fund's respective page at sofi.com. You may also contact customer service at: 1.855.456.7634. Please read the prospectus carefully prior to investing.Mutual Funds must be bought and sold at NAV (Net Asset Value); unless otherwise noted in the prospectus, trades are only done once per day after the markets close. Investment returns are subject to risk, include the risk of loss. Shares may be worth more or less their original value when redeemed. The diversification of a mutual fund will not protect against loss. A mutual fund may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.

Third Party Trademarks: Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®


¹Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.

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What Is Payment for Order Flow?

By | invest, Investing | Comments Off on What Is Payment for Order Flow?

When an investor places an order with their brokerage to buy or sell an asset, there’s a certain set of steps that take place behind the scenes to fulfill it. That’s referred to as an order flow, and that involves some payments between market makers and brokerages in order to keep orders moving through the pipeline. With that in mind, payment for order flow (PFOF) involves market makers paying brokers for their clients’ order flow.

It can be beneficial for investors to know about the order flow process and payments involved, as it is a variable in how much they ultimately end up paying for trading, if anything. And it’s also been a somewhat controversial practice, despite the fact that it’s become commonplace in today’s market.[1]

Key Points

  • Payment for order flow (PFOF) involves brokerages routing customer orders to market makers for a fee, enabling commission-free trading.
  • PFOF allows brokerages to offer commission-free trading, enhanced liquidity, and potential price improvements to retail investors.
  • Market makers provide liquidity in the options market, executing trades and offering price improvements to retail investors, and PFOF involves brokers routing their trades to specific market makers.
  • PFOF has faced controversy, with critics citing a conflict of interest for brokerages, which may prioritize revenue over the best prices for customers.
  • Regulatory scrutiny has been applied to PFOF, with the DOJ investigating potential market maker profiteering at the expense of retail investors; brokers today must adhere to specific regulatory requirements.[2]

What Is Payment for Order Flow (PFOF)?

Payment for order flow (PFOF) refers to the practice of retail brokerages routing customer orders to market makers, usually for a small fee that’s less than a penny. Market makers, who are required to deliver the “best execution,” carry out the retail orders, profiting off small differences between what shares were bought and sold for. Retail brokerages, in turn, use the rebates they collect to offer customers lower trading fees.

What Are Market Makers?

Market makers — also known as electronic trading firms — are regulated firms that buy and sell shares all day, collecting profits from bid-ask spreads. The market maker can execute trades from their own inventory or in the market. Offering quotes and bidding on both sides of the market helps keep it liquid.

Market makers that execute retail orders are also called wholesalers. The money that market makers collect from PFOF is usually fractions of a cent on each share, but these are reliable profits that can turn into hundreds of millions in revenue a year. In recent years, a number of firms have exited or sold their wholesaling businesses, leaving just a handful of electronic trading firms that handle PFOF.

In addition to profits from stock spreads, the orders from brokerage firms give market makers valuable market data on retail trading flows. When it comes to using institutional or retail investors, market makers also prefer trading with the latter because larger market players like hedge funds can trade many shares at once. This can cause big shifts in prices, hitting market makers with losses.

How Does Payment for Order Flow Work?

Here’s a step-by-step guide to how payment for order flow generally works:

  1. A retail investor puts in a buy or sell order through their brokerage account.
  2. The brokerage firm routes the order to a market maker.
  3. The broker collects a small fee or rebate – the “payment” for sending the “order flow” or PFOF.
  4. The market maker is required to find the “best execution,” which could mean the best price, swiftest trade, or the trade most likely to get the order done.

The rebates allow companies offering brokerage accounts to subsidize low-cost or zero-commission trading for customers. It also frees them to outsource the task of executing millions of customer orders.

Usually the amount in rebates a brokerage receives is tied to the size of the trades. Smaller orders are less likely to have an impact on market prices, motivating market makers to pay more for them. The type of stocks traded can also affect how much they get paid for in rebates, since volatile stocks have wider spreads and market makers profit more from them.

Why Is PFOF Controversial?

While widespread and legal, payment for order flow is controversial. Critics argue it poses a conflict of interest by incentivizing brokerages to boost their revenue rather than ensure good prices for customers. The requirement of best execution by the Securities and Exchange Commission (SEC) doesn’t necessarily mean “best price” since price, speed, and liquidity are among several factors considered when it comes to execution quality.[3]

Defenders of PFOF say that retail investors benefit from the practice through enhanced liquidity, the ability to get trades done. They also point to data that shows customers enjoy better prices than they would have on public stock exchanges. But perhaps the biggest gain for retail investors is the commission-free trading that is now a mainstay in today’s equity markets.

PFOF in the Options Market

Payment for order flow is more prevalent in options trading because of the many different types of contracts. Options give purchasers the right, but not the obligation, to buy or sell an underlying asset. Every stock option has a strike price, the price at which the investor can exercise the contract, and an expiration date, which is the day on which the contract expires.

Market makers play a key role in providing liquidity for the thousands of contracts with varying strike prices and expiration dates.

The options market also tends to be more lucrative for the brokerage firm and market maker. That’s because options contracts trading is more illiquid, potentially resulting in larger spreads for the market maker.

Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.

Criticism of Payment for Order Flow

Payment for order flow was pioneered in the 1980s by Bernie Madoff, who later pleaded guilty to running one of the largest Ponzi schemes in U.S. history.

Critics argue retail investors can get a poor deal from PFOF. Since market makers and brokerages are only required to provide “best execution” and not necessarily the “best possible price,” firms can make trades that are profitable for themselves but not necessarily in the best interest of individual investors.

As such, regulators have proposed reforms to PFOF, and in 2024, the SEC did adopt some amendments that updated required disclosures.[4]

Defenders of Payment For Order Flow

Proponents of payment for order flow argue that both sides — the retail investors and the market makers — win from the arrangement. Here are the ways retail customers can benefit from PFOF, according to its defenders:

  1. No Commissions: In recent years, the price of trading has collapsed and is now zero at some of the biggest online brokerage firms. While competition has been a big part of that shift, PFOF has helped bring about low trading transactions for mom-and-pop investors. For context, online trading commissions were $40 or so per trade in the 1990s.
  2. Liquidity: Particularly in the options market, where there can be thousands of contracts with different strike prices and expiration dates, market makers help provide trading liquidity, ensuring that retail customer orders get executed in a timely manner.
  3. Price Improvement: Brokerages can provide “price improvement,” when customers get a better price than they would on a public stock exchange.
  4. Transparency: SEC Rules 605[5] and 606[6] require brokers to disclose statistics on execution quality for customer orders and general overview of routing practices. Customers are also allowed to request information on which venues their orders were sent to. Starting in 2020, brokers also had to give figures on net payments received each month from market makers.

The Takeaway

Payment for order flow (PFOF) refers to the practice of retail brokerages routing customer orders to market makers, usually for a small fee. Payment for order flow has been controversial, but it’s become a key part of financial markets when it comes to stock and options trading today.

Industry observers have said that for retail investors weighing the trade-off between low trading costs versus good prices, it may come down to the size of their trades. For smaller trades, the benefits of saving money on commissions may surpass any gains from price improvement. For investors trading hundreds or thousands of shares at a time, getting better prices may be a bigger priority.

Invest in what matters most to you with SoFi Active Invest. In a self-directed account provided by SoFi Securities, you can trade stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, options, and more — all while paying $0 commission on every trade. Other fees may apply. Whether you want to trade after-hours or manage your portfolio using real-time stock insights and analyst ratings, you can invest your way in SoFi's easy-to-use mobile app.

Opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.¹

FAQ

What is payment for order flow (PFOF)?

Payment for order flow, or PFOF, refers to the practice of retail brokers routing their customers’ orders to specific market makers in exchange for a fee.

Why is PFOF controversial?

The crux of the criticism surrounding PFOF involves brokers putting their own financial interests ahead of their clients. Specifically, brokers may be more concerned with generating PFOF-related fees than ensuring their clients receive the best order flow treatment possible.

What are common defenses of PFOF?

Defenders of PFOF say that retail investors benefit from the practice through enhanced liquidity, the ability to get trades done, and low-cost or commission-free trading.

Article Sources
  1. Congress.gov. Payment for Order Flow: The SEC Proposes Reforms.
  2. Congress.gov. Payment for Order Flow (PFOF) and Broker-Dealer Regulation.
  3. FINRA. 5310. Best Execution and Interpositioning.
  4. SEC. SEC Adopts Amendments to Enhance Disclosure of Order Execution Information.
  5. SEC. Disclosure of Order Execution Information.
  6. SEC. 17 CFR Parts 240 and 242.

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.

For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.


¹Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.

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