It’s a common goal for people to want to pay off their mortgage in an accelerated manner. This goal is usually based around two underlying rationales.
First, people want to save money by reducing the amount they’re paying in interest. If you have a $200,000, 15-year mortgage with a 5% interest rate, you’ll pay more than $80,000 in interest payments. By paying off the mortgage as quickly as possible, there is a quantifiable financial benefit you’ll earn.
The other reasoning we typically see is security. Carrying debt adds an element of uncertainty to your financial situation. The peace of mind you have when you’re debt-free is something that many people highly value.
For those reasons, we’ll sometimes work with clients to accelerate how quickly they’re going to pay off their mortgage if they have liquid assets. One thing we tend to not recommend, however, is using using your 401k to pay off your mortgage.
You’ll Be Hit with Taxes—and Maybe Fees, Too
Let’s go back to our previous example and imagine you have $200,000 to pay off on your home with a 5% interest rate. If the money in your 401k is tax-deferred, you’re going to be paying income taxes on every dollar you withdraw. If you’re in the 25% tax bracket, you’ll actually have to withdraw close to $270,000 just to net $200,000 that you need to pay off your mortgage, and that’s without accounting for state income taxes. Suddenly, saving $80,000 in interest payments looks a little less attractive.
Even worse, if you’re under age 59.5 (or age 55 if you’re retired), you may be subject to a 10% early withdrawal penalty. Assuming a 25% income tax rate, you’d have to withdraw over $300,000 to net $200,000 after paying for taxes and fees—about $20,000 more than what you’d pay in interest payments during the life of your mortgage.
You Sacrifice Compounding Potential
Not only are you looking at a large, present day tax bill, you’re also significantly hindering the long-term potential growth you may be able to reap inside of your 401k. Let’s imagine two people, Tim and Tom, who are each 45 and have $350,000 in a 401k. Tim decides to withdraw $300,000 to pay off his mortgage, leaving him with $50,000. If he earns a hypothetical 7% annual rate of return, that $50,000 would grow to about $193,000 when he retires at age 65.
Tom, on the other hand, decides to keep that money in his 401k. His $350,000 would grow to about $1.35 million when he retires at age 65, over $1 million more than what Tim would have.
Risk of Being “House Rich and Cash Poor”
There are a lot of benefits you can receive by investing in a house, but the fact remains that a home is a largely illiquid investment. Remember, your 401k is there to help you fund your spending needs in retirement. Your home, on the other hand, isn’t something you can easily tap for income in retirement, meaning if you put a large portion of your savings into your home, you risk having difficulties generating enough income to maintain your standard of living in retirement.
All of this isn’t to say that it’s a necessarily bad idea to prepay your mortgage. But if the option boils down to carrying a mortgage or prepaying the mortgage with savings in your 401k, we think you’re better off holding on to the mortgage.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
This article originally appeared on May 28, 2017 in the Brainerd Dispatch. You may view the article here.
Prefer to listen? Here's how we approached this topic on the "Your Money" Radio Show:
Peg Chromy Webb has specialized in financial consulting for more than 30 years and is a popular co-host of the “Your Money” Radio Show. She is passionate about financial education and shares her expertise on career-building and financial literacy through various charitable endeavors.