Dear Dr. Don,
My wife and I have a combined $185,000 in two individual retirement accounts. We also have a slightly underwater mortgage with an estimated home value of $330,000 and two mortgages of $316,000 and $17,000. The first mortgage is an adjustable-rate mortgage, or ARM, that first reset in 2010 and currently is at 3.25%. We both are employed with decent incomes.
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My question is: Is it worthwhile to tap the IRA to pay off the second mortgage, which is at 8.5%? That way we could qualify to refinance our first mortgage in the near future. Our mortgages are unfortunately not backed by Fannie Mae or Freddie Mac, so we don't qualify for the federal programs to refinance an underwater mortgage.
We need help in deciding whether it's worth it to tap the IRA and pay the taxes, including a 10% penalty for an early withdrawal, so we can pay off the second mortgage and then be able to refinance the first mortgage. We both are in our late 30s, and we have two children, one in preschool and one in elementary school.
-- Casper Cache
First figure out if it's realistic for you to refinance your home after paying off the second mortgage. If your home is worth $330,000 and you have a first mortgage balance of $316,000, then the loan-to-value ratio is around 95% when you pay off the second mortgage.
You won't find a conventional lender that would let you borrow with only 5% equity in your home. Refinancing with a Federal Housing Administration mortgage can work, but you will have the added expense of its mortgage insurance premium.
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An alternative would be to cash out enough money from the IRA to get to an 80% loan-to-value, or LTV, ratio, the point where a conventional lender won't require private mortgage insurance, or PMI. I don't recommend this option. Eighty percent LTV on a home worth $330,000 means you take out a $264,000 first mortgage.
I don't know your marginal tax bracket, but that could mean taking out more than $100,000 from your IRAs to pay down $69,000 in mortgage debt, have the money available to pay the applicable income taxes on the distribution, and pay the 10% penalty tax.
If you're in the 25% marginal tax bracket, I estimate the needed distribution to be about $106,000, versus just $26,154 needed to pay off just the $17,000 second mortgage. You can use a Bankrate calculator to find your bracket.
Does it make sense to raid the retirement accounts to pay off the second mortgage so you can qualify for an FHA mortgage? It does if you're going to be in the house long enough that you want to lock in to a low, fixed-rate mortgage before rates start heading higher. You'd pay the income taxes on the distribution at some point anyway, although it could be at a lower marginal tax rate if you wait until retirement.
The 10% penalty for early withdrawal from the IRA becomes the main driver in the decision.
Would I pay $2,615.40 to get out from under an 8.5% mortgage on $17,000 and gain the option of refinancing with an FHA loan? I would in your shoes, if I planned on staying in the house long enough that I was concerned about the interest rate risk I faced with the adjustable rates on the current first mortgage.
Would I raid the IRAs just to get out from under the second mortgage? That's a tougher call. I don't think I would. I'd need the refinancing option to make it worth my while.
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