First, people want to save money by reducing the amount they’re paying in interest. If you have a $200,000, 15-year mortgage with a 5 percent interest rate, you’ll pay more than $80,000 in interest payments. By paying off the mortgage as quickly as possible, there is a quantifiable financial benefit you’ll earn.
The other reasoning we typically see is security. Carrying debt adds an element of uncertainty to your financial situation. The peace of mind you have when you’re debt-free is something that many people highly value.
For those reasons, we’ll sometimes work with clients to accelerate how quickly they’re going to pay off their mortgage if they have liquid assets. One thing we tend to not recommend, however, is using your 401k as the vehicle to pay off your mortgage.
You’ll Be Hit with Taxes—and Maybe Fees, Too
Let’s go back to our previous example and imagine you have $200,000 to pay off on your home with a 5 percent interest rate. If the money in your 401k is tax-deferred, you’re going to be paying income taxes on every dollar you withdraw. If you’re in the 25 percent tax bracket, you’ll actually have to withdraw close to $270,000 just to net $200,000 that you need to pay off your mortgage, and that’s without accounting for state income taxes. Suddenly, saving $80,000 in interest payments looks a little less attractive.
Even worse, if you’re under age 59.5 (or age 55 if you’re retired), you may be subject to a 10 percent early withdrawal penalty. Assuming a 25 percent income tax rate, you’d have to withdraw over $300,000 to net $200,000 after paying for taxes and fees—about $20,000 more than what you’d pay in interest payments during the life of your mortgage.
You Sacrifice Compounding Potential
Not only are you looking at a large, present day tax bill, you’re also significantly hindering the long-term potential growth you may be able to reap inside of your 401k. Let’s imagine two people, Tim and Tom, who are each 45 and have $350,000 in a 401k. Tim decides to withdraw $300,000 to pay off his mortgage, leaving him with $50,000. If he earns a hypothetical 7 percent annual rate of return, that $50,000 would grow to about $193,000 when he retires at age 65.
Tom, on the other hand, decides to keep that money in his 401k. His $350,000 would grow to about $1.35 million when he retires at age 65, over $1 million more than what Tim would have.
Risk of Being “House Rich and Cash Poor”
There are a lot of benefits you can receive by investing in a house, but the fact remains that a home is a largely illiquid investment. Remember, your 401k is there to help you fund your spending needs in retirement. Your home, on the other hand, isn’t something you can easily tap for income in retirement, meaning if you put a large portion of your savings into your home, you risk having difficulties generating enough income to maintain your standard of living in retirement.
All of this isn’t to say that it’s a necessarily bad idea to prepay your mortgage. But if the option boils down to carrying a mortgage or prepaying the mortgage with savings in your 401k, we think you’re better off holding on to the mortgage.
Bruce Helmer and Peg Webb are financial advisers at Wealth Enhancement Group and co-hosts of “Your Money” on KLKS 100.1 FM on Sunday mornings. Email Bruce and Peg at email@example.com. Securities offered through LPL Financial, member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment advisor. Wealth Enhancement Group and Wealth Enhancement Advisory Services are separate entities from LPL Financial.