A lot of homeowners would love to refinance at today's rock-bottom rates but can't because they're underwater on their mortgages. One possible solution: borrowing from a 401k plan to pay down the difference.
Borrowing from your 401k plan is generally considered a no-no, except under special circumstances. But the current housing market, with its combination of ultra-low mortgage rates and depressed home values, might qualify.
Being underwater, of course, means that you owe more on your mortgage than your home is worth. To be able to refinance, lenders typically require that homeowners in that situation "bring money to the table," that is, pay down the difference so the loan is fully covered by the value of the property.
Approval is automatic
There are a lot of advantages to borrowing from your 401k. For one thing, it's the one place where most middle-class homeowners can readily access enough cash to pay down the deficit on their mortgage. You can borrow up to $50,000 or half the value of your account, whichever is less.
It's also easy to do - you can't be denied for any reason. It's your money. You do have to pay it back to your account within five years or incur a penalty, but the interest rates are attractive - typically a couple of percentage points above the prime rate, which presently runs about 3.25 percent.
Also, you're repaying the interest to yourself. The entire repayment, including all the interest, goes right back into your 401k.
A multiplier effect
The advantage, of course, is that taking a relatively small amount out of your 401k may enable you to refinance a mortgage that is 5-10 times larger. You could find that your savings from refinancing your mortgage are far greater than what that same money could earn by staying in your 401k.
The downside is that it's likely to raise your short-term debt obligations, at least for the next five years while you're paying back your 401k. Also, the money you borrow from your account won't be able to appreciate tax-free, so that if the stock market surges between now and then, you'd miss out on those earnings.
Calculating the possible savings
Here's an example: Suppose you took out a $250,000 mortgage five years ago at 6 percent interest on a 30-year loan. Assuming regular monthly payments of $1,500 a month, you'd have that paid down to about $232,000 today, with 25 years remaining on the loan.
Let's say you've got good credit and can refinance at 4.5 percent, but your home is only worth $207,000 today. Assuming about $4,000 in refinance costs, you'll need to bring about $25,000 to the table to eliminate the negative equity and cover the new loan.
Refinancing $211,000 (remember, you're refinancing the lesser, paid-down amount) at 4.5 percent interest over 25 years produces a monthly payment of $1,173 a month, (a $327 a month reduction) reducing your mortgage payment by $327 a month and saving a total of $77,000 in interest over the life of the loan.
That's assuming you want to keep the same pay-off date you have now. Refinancing into a new 30-year loan (which adds 5 years to your present schedule) produces a monthly payment of only $1,089, (a $411 a month reduction), but your total interest savings will be only $44,000 over the life of the loan.
Don't forget, you still need to figure in the money you have pay back to your 401k over the next five years - if you don't, there's a 10 percent penalty. Paying back $25,000 over 5 years at 5.25 percent interest requires a monthly payment of $475 a month, which is more than what you'd be shaving off your monthly mortgage payment in either of the above scenarios. It's money you're paying back to yourself, but it's still $475 a month you need to come up with for the next five years.
Factors to consider
Whether borrowing from your 401k works for you depends on how the numbers work out for refinancing your own mortgage. Generally, things look better 1) the less you have to borrow 2) the longer the period you have left on your current mortgage, meaning potential savings on interest and 3) the bigger the difference between your current interest rate and the rate you can refinance at.
If you have only 10-15 years left on your loan, or need to borrow $50,000 to pay down a loan currently at $200,000, it's less likely to make financial sense. And if you only plan to stay in the home a few more years, refinancing may not be appropriate simply because you won't be there long enough to save more than the closing costs. Also, remember that interest paid on your mortgage is tax-deductable, so that will cut into the impact of your savings there.
To figure if borrowing from your 401k makes sense for you, you need to crunch the numbers. Use a mortgage calculator such as those at www.mortgageloan.com/calculator/ to determine what your new payments would be and what the total interest savings would be over the life of the loan.
If you're having trouble working out the numbers yourself, talk it over with a financial advisor. That's always a good idea, particularly if the amount you're planning to borrow from your 401k is substantial.
Finally, the above rules only apply to a 401k. You can't borrow from an IRA in the same manner, even though they're both set up as retirement accounts. If you do borrow from your IRA, you have to pay it back in 60 days. You can tap either a 401k or an IRA to obtain money for a first-time home purchase, but those rules don't apply to refinancing a current mortgage.