When Paying Off Your Mortgage May Make Sense
There may be good reasons to pay off your mortgage. It can save you thousands of dollars in interest, depending on the current size of your debt, and give you peace of mind that no matter what happens in the future, you own your home outright. Paying off your mortgage may make sense if:
- You have substantial retirement savings, especially if the funds you’d be withdrawing are in a taxable account and are not earning much interest.
- You’re downsizing. If you’re planning to sell your home for a smaller one, you can apply the equity to your new home, resulting in a modest mortgage or perhaps no mortgage.
Your mortgage is a factor in your retirement income plan and can affect your quality of life.
You May Have Time To Catch Up If Youre Under Age 35
If youre young and youve contributed consistently to one or more retirement accounts since you graduated, then you may have time to catch up to avoid delaying your retirement. You will need to commit to making larger contributions once youre back to being financially stable.
However, you will still face the withdrawal penalties and taxes described above. So, even in this situation, you should consult with a financial advisor to see how it will affect your retirement goals.
What Are The Rules For 401 Withdrawal
Tax-deferred retirement accounts, such as 401 plans and 403 plans, were designed to encourage workers to save for retirement. So the rules arent super friendly when it comes to withdrawals before age 59 ½.
Depending on your financial situation, however, you may be able to request what the IRS calls a hardship distribution. Employer retirement plans arent required to provide hardship distribution options to employees, but many do. Check with your HR department or plan administrator for details on what your plan allows.
According to the IRS, to qualify as a hardship, a 401 distribution must be made because of an immediate and heavy financial need, and the amount must be only what is necessary to satisfy this financial need. Expenses the IRS will automatically accept include:
Certain medical costs.
Costs related to buying a principal residence.
Tuition and related educational fees and expenses.
Payments necessary to avoid eviction or foreclosure.
Burial or funeral expenses.
Certain expenses to repair casualty losses to a principal residence .
You still may not qualify for a hardship withdrawal, however, if you have other assets to draw on or insurance that could cover your needs. And your employer may require documentation to back up your request.
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What Is The Rule Of Thumb About Paying Debt Vs Investing
In general, the rule of thumb is that you should both pay debts and invest. In fact, try to consistently contribute to three bucketsdebt payoff, retirement, and an emergency fundsaid Linda Davis Taylor, former CEO of Clifford Swan Investment Counselors in Pasadena, California, and host of the podcast Money Stories with LDT. Even if that means you can only contribute $10 or $20 per paycheck per month to retirement or savings in addition to debt payoff, its worth doing.
If you overcommit to investing and only make minimum debt payments, you could wind up paying too much in interest over time, he pointed out, which can hamper your ability to buy a home or start a family. If you neglect investing entirely, however, you may fall short of your retirement goals.
Buy A House The Right Way
Well give it to you straight: You should never, ever take money out of your 401 to buy a house. Period. If you dont have enough money saved for a down payment, youre not ready to own a house. Because homeownership comes with all kinds of other costs that could sink you if youre not financially prepared .
Leave the money in your 401 alone until youre actually ready to retire. Better yet, work with a SmartVestor Pro to make sure your investments are on track to meet your retirement goals.
The only time its okay to consider taking money out of your 401 early is to avoid bankruptcy or foreclosure. But thats a catastrophic financial situation. Wanting to get into a house faster is not the same thing.
So, if youve got the house fever, cool off, take a cold shower, and take a real, honest look at where you are financially. Theres plenty of time and better ways to save up for a down payment. Like we said before, 20% down is ideal because you wont have to pay private mortgage insurance as part of your monthly mortgage payment. PMI is insurance that protects the lendernot youin case you stop making your monthly payments. Lenders require it for all home buyers who put less than 20% down.
However, a 510% down payment will also workespecially if youre a first-time home buyer. Just be prepared for those PMI payments. And remember, the more you put down, the less you have to borrowand the faster you can pay that mortgage off and be completely debt-free!
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Dividing Your 401 Assets
If you divorce, your former spouse may be entitled to some of the assets in your 401 account or to a portion of the actual account. That depends on where you live, as the laws governing marital property differ from state to state.
In community property states, you and your former spouse generally divide the value of your accounts equally. In the other states, assets are typically divided equitably rather than equally. That means that the division of your assets might not necessarily be a 50/50 split. In some cases, the partner who has the larger income will receive a larger share.
For your former spouse to get a share of your 401, his or her attorney will ask the court to issue a Qualified Domestic Relations Order . It instructs your plan administrator to create two subaccounts, one that you control and the other that your former spouse controls. In effect, that makes you both participants in the plan. Though your spouse cant make additional contributions, he or she may be able to change the way the assets are allocated.
Your plan administrator has 18 months to rule on the validity of the QDRO, and your spouses attorney may ask that you not be allowed to borrow from your plan, withdraw the assets or roll them into an IRA before that ruling is final. Once the division is final, your former spouse may choose to take the money in cash, roll it into an IRA or leave the assets in the plan.
Given Current Rates Could Cashing Out Your 401 To Pay Off Your Mortgage Make You A Bundle
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Cashing out your 401 and using the proceeds to pay off your mortgage lets you borrow at a low rate and invest at a high rate and do so at no risk. Yes, your 2020 taxes will increase, but there will likely still be a large net gain. The fact that your 401 is invested in stocks doesnt matter. Once you adjust for the risk, investing in stock is no different from investing in todays low yielding long-term Treasury bonds. I.e., on a risk-adjusted basis, stocks are now yielding a very low return.
Arbitrage is when you can sell an apple for $3.00 and buy an identical apple for $1.00. The transaction nets you $2.00. Thanks to the extraordinary upheaval in financial markets from Covid-19, there’s a significant arbitrage opportunity available for millions of homeowners. It entails withdrawing funds from retirement accounts to pay off all or part of one’s mortgage.
Ideally, one would withdraw the requisite funds from Roth IRA accounts, since withdrawals from these accounts aren’t taxable. But given today’s mortgage and long-term government bond rates, the arbitrage can work even if you need to withdraw from a 401 or similar taxable account. It can even work if you have to pay the 10 percent penalty on making withdrawals prior to age 59.
Here’s a hypothetical example based on my software company’s MaxiFi Planner software.
The answer is a whopping $98,002, which almost fully makes up for Jack’s loss of earnings this year.
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What About Reverse Mortgages
A reverse mortgage, or home equity conversion mortgage , is a type of home equity loan for people 62 and older that converts a portion of home equity into cash. The lender makes payments to the homeowner, who maintains ownership of the home throughout his or her life. However, there are nuances to reverse mortgages, and the terms and conditions should be considered carefully since they affect your beneficiaries. In addition, because lenders require that you live in the home as your primary residence, youll need to repay the loan if you want or need to move.
Home Equity Line Of Credit
If you own a home and need quick cash to pay off a debt, you may be able to get a home equity line of credit . As the name suggests, this loan is secured by your home equity. HELOCs typically have lower interest rates than unsecured loans . However, if you default on the loan, your home could be foreclosed. In other words, this should be your last resort for paying off debt.
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Does Withdrawing From Your 401 Affect Your Credit Score
Borrowing from your 401 can put your retirement at risk, but it wont hurt your credit score.
Unlike applying for a credit card, no lender will do a credit check if you borrow from your retirement fund. And even if you miss payments or default on your loan, this information wont be submitted to credit-reporting agencies.
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Using A 401 Loan To Pay Off Debt
If you arent eligible for a hardship distribution and want to avoid the stiff tax penalties associated with cashing out your plan, you may have a third option. Some companies allow plan participants to borrow from themselves using a 401 loan.
These loans tend to carry a lower interest rate than alternative options, are not taxed and do not impact your credit score. Even if you have to pay an origination fee, the fee is likely lower than the tax penalties you would face from an early withdrawal. Yet there are some downsides to a 401 loan.
The most you can borrow against your 401 is 50% of your vested account balance, or $50,000, whichever is less. In other words, you cant just pull all of your retirement savings out. You can have more than one loan out at a time, but the total amount owed cant be more than the limit. Most 401 loans must be repaid within five years. If youre married, your employer may require your spouse to consent to the loan.
Plus, your employer may temporarily suspend new contributions into the plan until youve repaid the loan. That means that while youre paying back what youve borrowed, youre not adding anything else to the balance. The money you withdraw also doesnt have an opportunity to benefit from compounding interest, which could stunt your nest eggs growth. And if you separate from your employer before the loan is repaid, the IRS requires you pay the remaining loan balance in full within 60 or 90 days.
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Additional Options To Pay Off Student Loans
Tapping your 401 isnt your only option if youre having trouble paying off your student loans.
If youre dealing with financial hardship, consider these other options. Please note: most of these options only apply to federal student loans.
You should also contact your loan servicer. They can walk you through options that might help in your specific situation.
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Potential Pitfalls Of Taking Money Out
Before you decide on anything, review your strategy with your CPA and your financial planner. Its critical to address all of the details, and this page doesnt necessarily cover everything involved in the decision. If you have your heart set on getting rid of the mortgage, it might make sense to do it in stages.
A Large Tax Bill
When you withdraw funds from pre-tax retirement accounts to pay off a home loan, you typically create a substantial tax bill. Those costs may offset any benefits you get from getting rid of the mortgage debt. You pay a large tax expense today instead of paying modest interest charges in the coming years.
Example: Assume you owe $150,000 on your home, and you have assets available to withdraw. For simplicity, you and a spouse get $36,000 per year in Social Security benefits, and you withdraw $36,000 per year from your pre-tax retirement accounts for income.
In this scenario:
- Youre in the 12% federal income tax bracket .
- You might pay roughly $2,692 in federal income tax.
- You might be able to comfortably pay your mortgage during retirement.
But what if you withdraw $150,000 from your IRA to pay off the mortgage?
If you do so, your income is substantially higher for the year:
Remember that most of your monthly payment might go to principal if youre many years into your mortgage loan. An amortization schedule can tell you how much is going toward interest charges, which may help you decide whats best.
Access to Funds
Less Money for Spending?
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Can I Withdraw From My 401 To Pay Off Student Loans
You can withdraw money from your 401 and put it toward your student loan balances, but expect some limitations.
First, you can only pull money from the vested portion of your 401 the part you actually own. Your vested portion will depend on your employers plan and how long youve been with the company. Check with your HR department or plan administration for guidance.
You should also consider the disadvantages that come with withdrawing funds from your 401. If you decide to take money out, youll owe federal income taxes on the amount you withdraw. So, if youre in the 24% tax bracket and take out $50,000, youll pay $12,000 in taxes.
Additionally, if youre under age 59 ½, youll owe a 10% penalty for withdrawing from your 401 early. The only exception to this is called the rule of 55. This lets you avoid the 10% penalty if youve left your job and are 55 or turning 55 in the current calendar year.
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Should I Pay Off My Mortgage With My 401
The COVID-19 crisis has left millions of Americans unemployed and uncertain of how to make their mortgage payments and other debt obligations. In response to the need for emergency funds, the government created the Coronavirus Aid, Relief, and Economic Security Act which provided stimulus checks and better unemployment benefits. It also included provisions that allow people to borrow more money from their retirement accounts while waiving penalty fees for early withdrawal. For many, this might seem like a great way to pay off their mortgage now and reduce their debt load. However, every borrower should consider all the angles carefully before cashing out.
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Should I Use My 401 To Buy A House
There are good reasons for not using your 401 to buy a house. Even if youre comfortable with the 10% early withdrawal penalty, you will still be incurring long-term consequences by reducing your savings. That, in turn, will damage your future growth potential.
Taking out $10,000 from a $20,000 401 account, for instance, leaves you with only $10,000 that will continue accruing interest. With a 7% annualized rate of return, that $10,000 could become $54,000 over 25 years compared to $108,000 had you not withdrawn $10,000.
Withdrawing from your 401 account is essentially taking out a loan against yourself. If you want to pay it back, you also need to pay interest, and the time spent paying it back is time that could have been spent on growth.
Advantages Of Borrowing From A 401
Borrowing from your 401 isnt ideal, but it does have some advantages, especially when compared to an early withdrawal.
- Avoid taxes or penalties. A loan allows you to avoid paying the taxes and penalties that come with taking an early withdrawal. Additionally, the interest you pay on the loan will go back into your retirement account, although on a post-tax basis.
- Dodge credit checks. 401 loans also wont require a credit check or be listed as debt on your credit report. If youre forced to default on the loan, you wont have to worry about it damaging your credit score because the default wont be reported to credit bureaus.
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Are 401 Withdrawals Subject To Taxes And Penalties
Even if you can qualify for a hardship distribution, plan on paying taxes on the distribution . Unless you meet specific criteria to qualify for a waiver, youll also pay a 10% early withdrawal penalty if youre younger than 59 ½.
Now lets assume youre 33 years old, and you have enough in your 401 to withdraw the $20,000 you need. Right off the top, unless you qualify for a waiver, you can expect to pay a $2,000 early withdrawal penalty. Then, when you file your income tax return, that 401 distribution will most likely be counted as ordinary income, so it will cost you another 25% or so. If the added income bumps you into another tax bracket, your tax bill could be higher.
But taxes and penalties arent the only costs to consider when youre deciding whether to go the distribution route.
Compound interest creates the potential for your initial investment to grow significantly over time. So every dollar you take out now could mean several dollars less in retirement. Essentially, withdrawing from your 401 now is like borrowing money from your future self, because youre losing long-term growth.
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