The common objective for many people is to pay off their mortgage as fast as possible. This is based on two fundamental reasons. First, they want to save money on the amount of interest they are paying and, secondly, they wish to eliminate the mortgage so that they own the home free and clear. Peace of mind is something that many people value the most.
Therefore, if the company they work for offers a 401k and they have been contributing to it regularly, they will be tempted to use it to pay off their mortgage . Some people may also want to access just enough money from their 401(k) to avoid a possible foreclosure on their home mortgage . But, whether this is a good idea will depend on many factors which include interest rates, and your particular circumstances.
There are two ways you can use your 401(k) to pay off your mortgage: Taking out a loan or withdrawing funds.
Borrowing Money from a 401(k)
Taking out a 401(k) loan is easier than most loans, as all you need to do is notify your employer’s human resource department that you need a loan from your 401(k). The department will then notify the plan administrator of the firm that invests your 401(k). You could also just call your plan administrator directly and finalize the loan as it does not need a credit check. The maximum amount you can borrow is half of your 401(k) account’s total vested value but not more than $50,000.
How does a 401(k) Loan Work?
When you take a 401(k) loan you are essentially borrowing money from yourself and paying yourself back. Both the principal as well as the interest you pay goes back into your account. Your repayments will be taken out of your paycheck. It is not counted as taxable income and so you will not be penalized for early withdrawal. Most 401(k) plans have a repayment plan of up to five years.
It would make sense to borrow from your 401(k) if your mortgage interest rate is equal or higher than your 401(k). You could also get the advantage of the dollar cost average over the years as you pay off the loan. However, you should carefully plan the loan term in order to avoid overpaying interest.
Here are a few things to consider :
- Depending on the amount of the loan and the market returns the biggest possible cost will be the missed investment returns when the money is out of your 401(k).
- Your employer may not allow you to contribute to your 401(k) while the loan is outstanding. So your loan payments will not be counted as 401(k) contributions.
- If you leave your employer before you pay back your 401(k) you must repay the loan within 60-90 days, otherwise, the remaining balance of the loan will be treated as an early withdrawal and you will have to pay income taxes and 10% penalty (if applicable).
If you have a low balance payment on your mortgage or a substantial 401(k) balance then you might be able to pay it off. But as you can borrow only up to a limit paying off your mortgage in full may just not be feasible. So, the next option is to withdraw money from your 401(k) to be completely debt- free.
Withdrawing From Your 401(k)
Your 401(k) is intended for retirement and as you receive tax-deferral benefits you generally cannot withdraw money before you are 59½. If you withdraw any funds before this then you will have to pay taxes on the withdrawals as well as a 10% penalty. After you are 59½ you can withdraw funds from your 401(k) but you will have to pay the taxes on the withdrawal amount as the money to fund your 401(k) was taken from your paycheck before taxes.
Some of the factors in favor of living a mortgage-free retirement even if you have to use much of your 401(k) balance is that:
- It will allow you to stop paying interest on your mortgage especially if it is fairly early in the term and reduce your monthly expenses.
- Younger investors can use this amount to fund college expenses of their kids or purchase a vacation property. They can also rebuild the drawdown of their retirement savings over the years.
- The excess cash could prove beneficial if unexpected expenses arise during retirement like long time care or medical costs that are not covered by insurance.
- You will miss out on the tax-sheltered investment earnings on the funds that were taken out.
- A significant reduction of the total resources available during retirement, even though your budgetary needs will be more modest without your mortgage monthly payments.
- A higher tax bill in the year in which the fund was withdrawn.
- It could easily move a middle-income earner to a 25% bracket from what could have been a 15% one. This would cost about $10,000 in additional taxes.
However, the major downside of this is that:
There is no simple answer as to whether you should use your 401(k) to pay down your mortgage as it depends on your financial circumstances and your priorities. However, if you intend to pay back the cash you wish to take out to pay down your mortgage or use it to avoid foreclosure then you should consider taking out a loan instead of withdrawing funds.
Some people think that their investments are not growing so it is better off to withdraw money and pay off their mortgage. Whatever your reasons are for using your 401(k), you should consult an investment professional you can trust before doing so.