If you’ve been paying monthly mortgage bills for years, getting free from those loan payments can seem like a light at the end of a tunnel of debt. More money in your pocket, owning a home free and clear—sounds like a fantastic outcome.
Conversely, you may have heard that a mortgage payment provides a tax break, and you should invest your money in retirement savings instead of paying down your property debt. Which is better—reducing debt or growing your retirement fund?
If you’re considering using a 401k to pay off mortgage debt, keep reading for help in determining if this is a good choice for you.
The 4 Factors That Determine if This Is Right for You
With any big financial move, you need to start with research and the facts of your situation. For most people, the four factors below will lead to a logical decision.
#1 Rates of Return
Using interest-compounding funds to pay off a fixed-rate mortgage comes down to some simple math. If you take money that’s growing at a higher rate than your debt interest rate, you’ll lose money in the long run.
For instance, if your 401k grows at an average rate of 7% and your mortgage interest rate is 5%, then you’ll still grow the equivalent amounts of money at 2% by doing nothing.
#2 Time Until Retirement
When you calculate your rates of return, remember that retirement fund growth is most accurately measured over decades—in the current recession, your most recent 401k statement likely reflects loss rather than growth.
Look for a table in your 401k account that shows growth over the entirety of your 401k plan. If it’s more than a decade old, you should see some jagged leaps and drops that trend upward overall.
If your 401k funds stay in place, even if you begin regular 401k withdrawals, they should be able to stabilize.
#3 Your Age and Potential Penalties
Besides how many years your 401k has to recover before your retirement, your current age may trigger penalties. If you remove funds from your 401k before the age of 59.5, the IRS will charge you a 10% early withdrawal fee.1
To pay off a significant chunk of mortgage, that fee may wind up being in the thousands. If this 10% tax penalty will apply to you, add it to the calculations to determine if this is still a good move for your situation.
#4 Mortgage Size and Tax Costs
When you make a 401k contribution, it reduces your taxable income at that time. This is a smart arrangement based on the theory that when you withdraw funds in your retirement account, you’ll be in a lower income tax bracket and thus pay less in taxes overall.
Whether or not you’re over the penalty age, withdrawing funds from your 401k is still going to trigger it as taxable income. This can:2
- Add to your tax bill significantly if you’re taking out a large amount
- Move you into a higher income tax bracket by taking so much at once
Add the full potential tax costs when you do the math on this mortgage pay-off option.
Pros of Paying Off Your Mortgage With a 401k
The sheer pleasure of owning your home free and clear is a big attraction for some. Benefits include:
- Pay off your mortgage without reducing accessible cash and savings
- Less worry over the impact of market fluctuations on your 401k
- Reduce the total amount of interest payments you pay on your mortgage
- Increase your available cash on a monthly basis
- Turn your home into a fully owned, 100% equity vested asset
Cons of Using Your 401k to Pay Off a Mortgage
For most people, using a 401k to pay off a mortgage costs more money than it saves. The cons break down to:
- Reduce the funds that could grow in your 401k investments
- Cost money by taking higher-rate investments to pay for lower-rate debt
- Add the withdrawal amount to your taxable income and increase your tax bill
- Put direct responsibility on you for property tax and home insurance payments
Other Options to Pay Off Your Mortgage
If you’re looking to pay your mortgage off more quickly, there are many ways you can shorten the length of your loan and add income that can be used toward your mortgage, such as adding a tenant to your property.
To pay off your mortgage in its entirety without tapping your 401k:
- Borrow against other retirement assets that are not tax-advantaged
- If downsizing or traveling is in your plans, consider selling
- Selling a house with a mortgage is possible, and you can use your home equity to pay off your mortgage with a sale-leaseback solution
- Access savings certificates or bonds that earn less than your mortgage interest
Still asking yourself, “Should I pay off my mortgage with my 401k?” The best way to proceed is to learn about all your options. You might consider comparing a home equity loan vs. 401k loan, however, there are other options like using a sale-leaseback program to pay off your mortgage with equity and keep your 401k intact.
- IRS. 401(k) Resource Guide – Plan Participants – General Distribution Rules. https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules
- Principal. Should I use my 401(k) to pay off my mortgage? 5 things to consider. https://www.principal.com/individuals/build-your-knowledge/should-i-use-my-401k-pay-my-mortgage-5-things-consider