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Should I take money out of 401(k) retirement savings to pay off a mortgage?

June 16, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Q: My husband is 34. He is debating whether to use an old 401(k) from a previous employer to pay off the house. He has a new 401(k) that has about $15,000 in it and plans to leave it alone and continue to contribute to it. The 401(k) in question has about $130,000 in it. We owe $81,000 on the house and have 24 years left on the mortgage. So, after early withdrawal penalties and taxes, we'll have enough to pay off the house, which will save us like $62,000 in interest over the life of the loan and free up about $600 a month. But is the cost of cashing that out worth it? Any advice would be greatly appreciated.

A: Saving $62,000 in interest over the life of your mortgage sounds tempting. However, the other side of the equation is what you would have to give up to obtain those savings. When it comes to early withdrawals from a 401(k) plan, the price is generally not worth it. This may be especially true in your case because there may be alternatives to withdrawing from this fund that could save you a substantial amount of interest expense on your mortgage without causing you to take a hit to your 401(k) retirement savings.

Tax penalties vs. mortgage interest savings

Since your husband is younger than 59½, taking money out of his 401(k) to pay off your mortgage will mean first having to pay a 10 percent tax penalty for the early withdrawal, plus whatever tax rate you normally pay on income since the income tax was deferred when the money went into the plan.

Future investment earnings in danger

As a result, you are going to have to take out considerably more than $81,000 in order to have $81,000 left over after taxes to pay off your mortgage. Now think about the future investment earnings you will miss on the amount you take out. Even at a very modest rate of return, these earnings could very easily exceed the interest you would save on your mortgage. To find out how much your retirement fund will be worth in the future, use a retirement savings calculator to better inform your financial decisions.

Alternative to early withdrawals: Refinancing mortgage

Since you are six years into your mortgage, there is a good chance that the original loan was at a substantially higher interest rate than current mortgage rates. In this case, refinancing could save you a fair amount of interest, without you having to pay the tax penalty or give up future earnings on your current 401(k) balance.

Better yet, with six years of your loan paid off and refinance rates much lower these days, you could consider refinancing to a 15-year loan. In the long run, this would save you money in two ways. Rates on shorter mortgages are much lower than on 30-year home loans, plus you would save by paying interest over fewer years. In the near term, you would probably have to cope with a higher monthly payment, but you might find that the lower interest rate means this is affordable and well worth the long-term savings.

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