Q Dear Rick:
I am in my mid 50s and I plan to work for at least another 10 years. Probably for the last 10 years I’ve had an adjustable rate mortgage and the rate has always been very favorable. Recently, I received my adjustment and the rate went up. My current rate for the next year is going to be four percent. I am questioning whether it makes sense to pay off my mortgage or not. Currently, I owe about $125,000. I currently have about $50,000 that I have in a money market account that is virtually paying nothing. I was thinking of using that and then for the remaining money, to borrow from my 401(k) Plan. I’ve talked to my employer and they say I can borrow without a problem. My question to you is from an economic standpoint, what should I do?
Dan
A Dear Dan:
I have no problem taking the money that you have in the bank which pays virtually nothing and using that to pay down your mortgage. However, I do think it is a mistake to borrow from your 401(k) Plan. I believe you’d be much better off by keeping the money in a 401(k) Plan, where in the long run, it will get a much better return than the after tax cost of your mortgage.
There are many people who believe that when you borrow from a 401(k) plan it basically is interest free because you’re paying the interest to yourself. Although there is some truth to this, there are some other issues that you need to consider. The first issue is the fact that the interest you will pay will be non-tax deductible. Therefore, you are taking after tax money, using that to pay yourself interest and eventually when that money comes out of the IRA you will pay taxes on it. Therefore, the interest you thought you were just paying to yourself results in you eventually paying more taxes. In addition, another factor you have to consider is the fact that in many 401(k) plans, if you have an outstanding balance, you cannot make new contributions. This can also mean that if your employer had a max, you may lose out on it.
I’ve always been a believer that retirement money is sacred and that for most people it is a mistake to use it prior to retirement. Particularly in your case where you will be working for at least another 10 years and during that 10-year period you will be deducting the cost of the mortgage. Therefore, the cost of the mortgage really isn’t the four percent but rather, it is probably closer to three percent or even less, when you consider that you are deducting the mortgage interest. Over the long run, your investments should earn more than the three percent and thus, from a purely economic standpoint, at this point in time, paying off the mortgage, particularly by borrowing from a 401(k) plan, is probably not the most economical thing to do.
One last note; I do love the idea that you want to pay your mortgage off and therefore, what you may also wish to do, in addition to using the money market to pay down the mortgage, is begin making extra payments on the mortgage. By making an extra payment or two every year, it will significantly reduce your mortgage balance.
I recognize that for many people borrowing from a 401(k) Plan is the easiest way to obtain money. However, something everyone needs to keep in mind is that no matter how much you think you’ll need for retirement, you will need more. Therefore, by tapping into your retirement account early, it may give you short-term relief and comfort; however it could cause you some long-term pain.
Good luck!
Rick is a fee-only financial advisor. His website is www.bloomassetmanagement.com. If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com