The closer my husband gets to retirement, the more time I spend working on a post-retirement budget. I cannot tell you how much it bugs me that we’ll go into his retirement with a mortgage payment.
Last week, it occurred to me that we’ll have enough put away in our retirement accounts to pay the mortgage off once he’s put away his briefcase for the last time. I spent last weekend researching the idea and am now convinced that pulling money from retirement funds to pay off our mortgage is a terrible idea. Here’s why.
The tax bite would be too painful
Let’s say someone used their 401(k) to pay off their mortgage. If they were under age 59 1/2 when they made the withdrawal, they’re automatically hit with a 10% penalty.
They also had to pay Uncle Sam his share because they didn’t pay taxes on the funds when they contributed to the account. That means paying federal taxes on the amount they withdrew. And if they live in one of the 43 states that levy a state tax, they’ll also owe the state.
Withdrawing funds from a 401(k) to pay off a mortgage after age 59 1/2 means no 10% penalty. However, since the amount withdrawn must be added to regular annual income, you can still count on getting hit with any state and federal taxes due.
Years of missed interest
Suppose someone has $500,000 in their 401(k) and withdraws $150,000 to pay off their mortgage. Here’s what that would mean for them:
- They’re taxed on the money as though it’s part of their regular income.
- Depending on their age, they may also be responsible for a 10% penalty.
- Instead of $500,000 growing in their account, they’re down to $350,000 ($500,000 − $150,000).
- If the annual return in their investment account averages 7%, they miss out on the money they could have earned on the $150,000. Over 10 years, that means losing out on a little more than $145,000 in earnings.
The younger a person is when they withdraw money, the higher the odds are that the missed returns will be larger than the original sum they took out to pay off the mortgage.
Other options
I understand the desire to own a home free and clear, and I would love it if that were the case for us. However, raiding our retirement account is not the only option. Here are some others.
Pay more than required each month
Putting extra money toward the loan principal each month shortens the time it takes to pay your mortgage off and saves a bundle in interest.
Let’s say a person owes $400,000 on a 30-year mortgage. Their interest rate is 5.5%. By paying $200 extra each month, they shorten the time it takes to pay the loan off by 5 years and 3 months. And because they paid the loan off sooner, they saved $85,713 in interest.
Refinance to a shorter term
Normally, refinancing a mortgage to a shorter term means scoring a lower interest rate, but for the sake of this illustration, let’s say that the rate remains at 5.5%. A 30-year mortgage on $400,000 results in a monthly payment of $2,271 (principal and interest only).
Shortening the term to 15 years means the payment jumps by $997 to $3,268. However, the loan is paid off in half the time, saving $229,314 in interest payments.
Make biweekly payments
Paying one-half a mortgage payment every two weeks means you pay one extra payment a year (52 weeks ÷ biweekly payments = 26 half-payments). When you make a single monthly payment, you end the year with 12 whole payments. When you make 26 half-payments a year, you end the year with 13 whole payments.
That extra payment makes a difference. Biweekly payments on a $400,000 loan at 5.5% results in paying the loan off in 25 years instead of 30 and saving $80,718 in interest.
Recast your mortgage
If mortgage interest rates drop between now and my husband’s retirement, we plan to refinance at a lower rate. Even if they don’t drop, we like the idea of recasting the loan shortly before he retires.
Recasting a mortgage is less expensive and less of a hassle than refinancing. It would require us to make one large, lump-sum payment. For example, if we owed $300,000 on the mortgage at the time, we might pay $100,000.
At that point, the lender would adjust our loan balance to $200,000 and refigure our monthly payment based on the new, lower balance. We would keep our current interest rate, but our monthly payments would drop due to the lower balance.
You can also mix and match. For example, you can make biweekly payments and pay a little extra toward the principal. The good news is there are options that don’t involve raiding your 401(k).
Ideally, we’d all enter retirement with no debt. If, like me, that may not be a reality for you, it might be OK. Make it a goal to eliminate any other debt. Once you work your post-retirement budget, you may find that a mortgage payment fits just fine — especially if it’s the only debt you carry.