Dear Dr. Don,
I have a $600,000 loan on a home with a current market value of about $500,000. It's a fixed-rate mortgage at 6%. I am 60 years old. My wife and I currently make about $200,000 per year.
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Should I take money out of my 401(k) and refinance at a lower rate? I'm obviously not getting that kind of return on my money in my 401(k) now. But do the tax implications offset the savings?
-- Scott Strategy
Your ability to tap your 401(k) balance while you're still working is limited by the provisions of the 401(k) plan. The potential options are: a plan loan, an in-service withdrawal (a withdrawal before retirement or some other triggering event) or a hardship distribution. It's unlikely you would qualify for a hardship distribution.
Plan loans, if your 401(k) plan allows them, are typically limited to half your vested account balance or $50,000; whichever is less. That's not enough to accomplish your financial goal of refinancing your home. For a 401(k) plan to offer in-service withdrawals isn't all that common, but you can check with your plan administrator.
The math quickly gets ugly. If we assume the lender is willing to make a loan at 80% loan-to-value, you're eligible for a $400,000 first mortgage. That means you need to bring $200,000 to closing. A 20% mandatory withholding tax on your 401(k) means you would reduce your plan balance by $250,000 to do so. The actual tax rate on the distribution is likely to be higher than the mandatory withholding amount because the distribution is counted as income in the year received.
A 90% loan-to-value first mortgage will require private mortgage insurance, or PMI, which reduces the benefit of refinancing, and you still need to bring $150,000 to closing.
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An 80-10-10 mortgage has you taking out a second mortgage for 10% of the appraised value along with an 80% loan-to-value and 10% down payment. The good news with the 80-10-10 loan is you don't pay PMI. The bad news is the second mortgage typically has an above-market interest rate, reducing your savings from refinancing. You would still need to bring $150,000 to closing. These loans, called piggyback loans, also have become less common since the mortgage meltdown.
Take a look at the Home Affordable Refinance Program, or HARP, and see if you qualify. Recent changes in the program make it easier for homeowners to refinance when their loan balance exceeds the home's value.
If you don't qualify for the government's refinance program, I'd suggest dialing down your 401(k) contribution to the limits of the company's contribution matching program and taking money out of current income to chip away at the existing loan balance. You can do this by making additional principal payments. That, combined with any potential appreciation in home prices, may get you to the point where you can refinance without bringing a wad of cash to closing.