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Should I borrow against my 401K to pay my mortgage off? That question eventually comes to mind for any homeowner who is also fortunate enough to have a 401k retirement plan.
The answer is YES you should. This isnt the popular answer and if you google the question, the first ten pages of results will have you feeling dumb for having ever considered it. Well heres the flip-side of the opinion and why we think paying off your mortgage is one of the smartest financial moves you can make.
The 401k Conundrum
Your 401k account likely allows for borrowing against it in the lesser amount of $50,000 or 50 percent of your current holdings. The repayment period for a 401k mortgage loan is usually set at five years.
No credit check required. If you want the money, its yours to borrow. If your credit score is low and you long to achieve mortgage freedom, the 401k is an attractive solution for many.
The down-side is that you repay the loan with money from your paycheck, after its been taxed. You then have to pay tax on it again after you retire and draw it out. You also lose years of compound interest on any amount you take out.
Whats the risk and is it worth it? Thats the conundrum. Lets look at the situation in a different light than your financial investor will shine.
OPPORTUNITY COSTS
Way back in your first year of college, you might remember a lesson on something called opportunity costs. Opportunity costs arent about numbers. Theyre about quality of life. In the case of a mortgage, its asking What are you giving up every month to make your house payment?.
You see, life isnt all about numbers and accountants that try to argue the merits of home loans, backed purely by numbers, are doing you a disservice.
Could you end up with a few thousand more when you retire by letting your 401k max out and never touching it? Easily. Is that all you should be considering? Absolutely not.
Paying off your mortgage today means not having to write that $1000-$2000 check next month.. or the month after that.. or ever again. What could you do with that kind of money every month, over the course of the next 30+ years? What are the opportunities created by having this money on hand every month while in the prime of your life?
Its fair to say that by paying your home off now, you could spend the next few centuries enjoying life in a way that would have never been otherwise possible. You cant measure quality of life on a calculator. Its dozens of vacations you would have never been able to experience, eating out more often every month, allowing the kids to enjoy life on a grander scale and buying those little extras in life every day, without having to check the bank account balance first.
What kind of price can you put on these things? We would argue that this is priceless, but lets look at the cost in terms of numbers. How much are you really losing anyway?
The Math
Salary:401k Contribution (%):Employer Match (%):Estimated Rate of Return (%):Years until retirement: CalculatorPro.com
From the 401k calculator above, we can estimate long term earnings with about the same accuracy as any professional financial adviser (scary but true). Lets plug some very average American numbers in and create a comparison of borrowing against our 401k vs letting it fully mature.
Joe makes $60,000 a year. Hes 30 years old and has been working at the same company for eight years. Hes been contributing 8% to his 401k since day one and hes never touched it. His employer matches 3% and well assume his money earns him 6% long-term. He currently has amassed $90,000 towards retirement.
If we plug those numbers into the calculator and assume Joe to retire at 65, hes got 35 more years of labor and hell end up with just over $1,500,000 on retirement. Not too shabby.
Joe bought a new house when he landed his job and has a 30 year mortgage on a $150,000 home. Hes eight years into his note.
Joe put 5% down on his home when he purchased it and has a 6% interest rate. This equates to a monthly house payment of almost $1100 a month. you’ll see that Joe will have paid a whopping $307,569.42 in principal and interest costs at the end of his 30 year loan. His house ends up costing him over twice what he initially visualized paying for it.
The mortgage calculator also shows us the amortization schedule, revealing that most of what Joe paid the first ten years has been towards interest on his home.
In the first year, he spent about $8,500 on interest payments and almost $1,800 went towards his principal. Interest goes down every year and in his tenth year of home payments, Joe has paid nearly $3000 in principal and just over $7,200 in interest. His remaining balance is $118,994.06.
Joe is considering cashing out some stocks he has and taking the full $45,000 available to him on his 401k to pay off his home. Between the two, hell have just enough money (with a few thousand left for emergencies if hes wise) and as of next month, he wont be pissing his money away in interest every month.
The down-side is that hell be repaying his loan with after-tax money for the next five years and giving up compound interest on the life of money removed from his 401k. Considering the total interest on the life of the mortgage, its a good option.
Hes also cashing out stocks. Bad move? If you have a crystal ball and can foresee the future, that would be an easier argument. In 2008, the stock market took a huge nose-dive and the average loss on funds was 38 percent. All those people who exercised their 401k loans in 2007 were looking pretty brilliant in 2008.
Remember the Great Depression? Youre likely not old enough to have experienced it, but you know the story. Think that couldnt happen again? Its certainly arguable that anything could happen in a market fueled by emotion. Wouldnt it be nice to own your home if those conditions resurfaced?
At $45,000 for 5 years, Joes home will be paid off and his 401k repayment will come directly out of his paycheck. Hell get a prime interest rate on his 401k and that interest gets paid back into account as well.
Hes probably looking at paying back an extra $5,000 and having monthly payments of about $450.00 taken directly out of his bi-weekly check every month for the next five years. His monthly payment has gone down and hes going to save over $80,000 of interest still left on the life of his house loan.
He can work on paying extra too, and why not? An extra $187.50 added to the payoff over the next four years puts the payment at his current amount and the loan is repaid in full in four years.
If he has repaid his loan on time, he has lost just under $14,000 on his 401k earnings and the compound interest going forward.
Hell also need to factor in paying his home taxes every year (around $1000) and the fact that he can no longer claim a tax deduction on mortgage interest every year. All of that does add up but guess what? Joe has an extra $1100 to spend every four weeks for the next 15 years.
Maybe Joe has a business opportunity comes along after his home is paid off? A $50,000 home equity loan is going to be pretty easy to get. Without paying the home off in advance, theres a good chance that blue-collar Joe would never have the opportunity to take a chance on owning his own business.
The Risk
Cashing out your 401k to payoff the mortgage isnt for everyone. Its a risk but so is keeping your money tied up in stocks over the next 30 years. Youll have to weigh this out and make the best choice for yourself.
The biggest risk in using your 401k comes with losing your job. If you are fired or laid off, most 401k loans require that you pay back the entire amount within 30 days, as well as a 10% early withdrawal penalty. Thats a tall order for an unemployed person. Quitting your job and taking another carries with it the same penalties. Youre essentially locked into your job for the repayment period.
How confident are you in the security of your job? Thats a big question that requires a very honest answer before signing on the dotted line.
If you have no other source of emergency funds, you might want to think a while before borrowing from your 401k. If you have a rich mother in law that would step up in a worst case scenario, jump in.
Dont Borrow If
Borrowing to pay your mortgage off just makes sense. Were not talking about creating a hardship for yourself when youre older. Were advocating a balanced life and ensuring happiness at both ends of the age spectrum. Were encouraging a stream of income for the next 20-30 years and increasing quality of life in a big way while having plenty left to enjoy the golden years.
Is it possible that this means youll end up with $850,000 at retirement instead of $950,000? Sure its possible. Is that worst case really so terrible, if you have an extra $1,100 to spend every month for the 25 years prior?
Its also possible that by freeing up 15 years of home loan payments, Joe will be able to move his 401k contribution from 8% to 15% and end up with more money on retirement. Its possible that Joes new business purchase took off and he created a far greater retirement that he had ever dreamed.. all made possible by freeing up mortgage payments.
Need yet another reason to consider paying off that mortgage? Maybe youll be dead before you ever get the opportunity to retire? Its a reality that happens to thousands and thousands of people every day.
Pay that mortgage off as soon as possible. The view from the porch swing looks even better when that home is truly yours and youre no longer just leasing it from your lender. Youll be pretty happy with your decision when youre ordering that $250 bottle of Occhio di Pernice for dinner while vacationing in Italy with the kids.