While a second mortgage presents a great opportunity to generate cash when one is experiencing tight cash flow, many homeowners have the choice of borrowing against their 401(k) plan as well.
This presents a very difficult dilemma for the borrower.
On the one hand, the family home is at stake. Losing it can mean losing a roof over every family member’s head.
On the other hand, the retirement funds is on the line. Losing it can mean a later retirement.
Both are invaluable assets that plays a huge role in one’s life.
One is a physical asset with paper value, while the other is cash at a later stage in life.
What’s the relative costs of interest?
The critical element here is to calculate how much it will actually cost the borrower after taking tax into account.
For example, for a home equity loan via second mortgage, deducting tax savings from the interest rate would get you the after tax costs.
This is calculated by:
- i = interest rate
- t = tax bracket
If the interest on the home equity loan is 5% and the tax bracket of the borrower is 33%, then we work out the numbers with 5 x (1-0.33), resulting in a figure of 3.35%.
In the above example, the after tax cost is 3.35%
The cost of borrowing against your 401k is the opportunity costs. Which refers to what the funds would have earned from interest should it be kept in the 401k.
Because money in 401k is basically tax-free until retirement, the interest one would earn on it is effectively it’s after tax cost.
When deciding to go with a loan against 401(k) or a second mortgage, if we go by the logical pragmatic approach, the option that has the lower after-tax cost will be the winner.
However, we all know that not all decisions are logically made.
Implications of unemployment
It’s a little odd to say that you career can play a role in all this. But it is what it is.
Should one borrower against his 401k and gets retrenched, if we go by the books, the loan has to be repaid within 60 days of unemployment to retain it’s tax benefits.
Failing to do so can result in financial penalties that will send your after-tax costs over the edge.
For a second mortgage, the lender has no right to accelerate the loan due to unemployment and everything will remain as they were as long as the borrower continues to meet his monthly debt obligations.
Failing which can lead to foreclosure.
Which one to choose?
This is really a tough decision to make. Especially when after-tax costs turn out to be very similar with little variance after calculations.
Consider that on one side, we have a profit-driven lenders that probably has little issue to destroy your life.
On the other side, we have a government agency whose goal is to serve the public.
After weighing up quantitative factors, qualitative factors should also be taken in account when deciding which one to borrower from.
Borrowing from 401(k) to pay off second mortgage
Because of how easy it is to borrow from your 401k, it is commonly thought of as an option to repay a primary or second mortgage with.
One can basically obtain automatic approval for an amount up to $50,000, and for a term of up to 5 years.
And due to the attractive interest rates, it can be a shrewd financial move to save money on an expensive home loan.
The problem is that it can increase your short term debt obligations significantly.
For example, should you have an outstanding second mortgage of $30,000 with 15 years remaining on it, taking on a 5 year loan to pay off that $30,000 will theoretically triple your monthly installment on that $30,000.
However, the interest savings might still be worth it.
It goes without saying that you need to be financially sound to restructure your debt this way. Otherwise, the increased monthly debt commitments might drag you under very quickly.
Just be mindful that should you be unable to repay towards your 401k within 5 years, you are going to incur a financial penalty.