Last week I received an email from “Jim” who was responding to my article on refinancing your home to a lower interest rate.
My wife and I want to refinance our home to a 15 year fixed rate. We have a 30 year loan at 6% and our local bank is offering 4.5% fixed on a 15 year loan.
There is a problem… homes in our area have depreciated in value over the last two years and we have basically no equity in our home even though we originally put 10% down when we bought it.
The loan officer says she needs me to bring an additional $15,000 to closing to bring the loan to value down. Other than a 401k I have no additional savings.
Should I borrow money from my 401k so I can refinance my house to a lower interest rate?
This is a very good question and one that I can relate to having recently refinanced our home from a 30 to a 15 year fixed.
In my article on borrowing from your 401k, I advised against the practice saying that it should be avoided except in extreme circumstances such as avoiding bankruptcy or covering unexpected medical costs.
On the other hand, borrowing from your 401k, 403b, or IRA so that you can refinance your home from 6% to a 4.5% interest rate may be a reasonable option if the circumstances are right.
For example, if you were refinancing $300,000 from a 6% note to 4.5% note you would save about $4500 the first year in interest payments. If you had to borrow $15000 from your 401k to make this happen, you are effectively getting a 30% return on your “investment” ($4500 savings / $15000 loan = 30%).
This 30% return is in additional to the interest that you are paying back to yourself by borrowing money from your 401k (as is the case in most 401k plans).
A 30% guaranteed return on your investment is a no brainer in my opinion, but then again I’m just a guy who has made some foolish mistakes with money! With that said, if I were in a similar situation I would strongly consider the 401k loan.
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{ 13 comments… read them below or add one }
Hmm, that is an interesting question… my first inclination is an immediate NO to borrowing from the 401k but the numbers are interesting.
I think I’d first have to explore other options for raising the money. Is there an Emer Fund, are their monthly Snowball funds that can be tapped, is their a car that can be liquidated… together can these funds bridge the gap?
Then I’d have to look at the actual loan… can I get a good rate on a 20 or 30 year mort that requires less money up front? Can the broker lock the rate for 60 days while I find money somewhere else.
Like you said, don’t tap the 401k unless it’s an emergency. IF this is going to qualify as an emergency, then we must chase every other possible avenue before just saying OK and jumping in.
Finally, I’d have to evaluate my job – that is the biggest single risk with 401k loans. The math works ok… but borrowing from the example we’re looking at a 3+yr repayment period – provided ALL mort savings are plowed back into the 401k.
Can I keep this job for 3+ years in this economic climate? Do I want to keep this job in any economic climate?
Is there a combo of any of the above that works for me? For example – can I lock the rate for 60 days – save $2000 in snowball payments over this period, sell my boat/atv/motorcycle/other toy for $5000, squeeze and extra $500 from the budget for a total of $7500… or half the money… then borrow the rest??
It’s a close call… but I’d have to close the gap on 3+ years before I sealed the deal… but this is a GREAT discussion point.
Thanks for sharing!
Dave
Thanks for those excellent points Dave! As a Dave fan myself, I agree that it is not always about the “math”.
Each person’s situation is unique and even Dave Ramsey himself has a disclamer at the end of his radio show program.
If I were do as I suggested in the article, I would definately ensure that I had an emergency fund in place (at least 3-6 months). No one’s job is completely gauranteed for 3+ years, but I certainly wouldn’t want to go down this avenue if I were employeed in a high risk industry.
Another good point is looking at all available means to come up with the cash by selling “toys”, other property, etc.
Thank you for your insight, and I hope your day is “better than you deserve” ha!
What about risk? The 401(k) note is due when he leaves the company. He get’s laid off the note must be paid in full with in 90 days. Hard to refinance that $15k when your out of work. So he gets hit with 10% penalty + Fed tax rate + state take rate. That could easly end up in the 35-40% range.
You also have to consider that they are paying back the 401(k) loan with after-tax money. For example, if their payment for the 401(k) loan is $200 per month and they are in the 25% tax bracket, they need to make $266 gross pay in order to pay back that $200 from the loan. That is a fairly big “penalty” to me. I would advise them not to take the money out for that reason and the one that Bill just pointed out. They will also miss any big swing that we have in the market. Just too many risks.
Adam,
I agree that you could “possibly” loose out on returns on the market, but he would be gaurunteed a return of 33% with his initial investment.
There is definately a concern about the risk, and Dave and I both agree that it may a reasonable if you are relatively secure in your job, you have a decent emergency fund, and you have exhausted all other avenues of obtaining the cash required for closing.
As far as paying tax on your 401k loan payments, if you were in the 25% tax bracket as you mentioned, you would have to earn $266 to buy anything whether it was a loan or not.
The 33% return is based on the assumption of a $300k loan. You may have more information than us, but the article mentioned that the bad market had wiped out his equity. The bankers are demanding $15k down to adjust the LTV ratio, so we can assume the 15k is at least 10% down, and hopefully if the bankers learned any thing the 15k is a 20% down. So the return is no ware near 30%.
You also mention a full emergency fund to offset risk while the article says “Other than a 401k I have no additional savings.”
Bill,
You’re right, $15k would not suffice to bring the LTV in line on a $300K loan, so more likely his mortgage balance is $100k or less.
I was looking at it from an “if it were me” perspective, hopefully “jim” will chime in here and give us more information to help!
I feel like the 800 pound Gorilla in the room is whether the refi is a good idea, regardless of whether the 401(k) should be raided. There is always a crossover period with refis, and I would first decide whether the refi was a good idea.
A Great calc can be found at Dinkytown and it will give you, to the month, that the refi becomes a good idea.
Damn your good…. will have to send any questions of this nature your way
.
no, no, no, no, NO!!!!!
Ok. Never mind I don’t advocate borrowing or cashing out a 401k under any circumstances barring imminent death. But really. This is not an emergency and the consequences could be huge.
First of all, you have no other savings. None. Before you even start talking about borrowing more money from anyone for any reason, you need an emergency fund. Otherwise you’re digging your own grave, financially at least.
Secondly, no one’s job is that secure. 401k loans sound like a great idea, but they’re really just another way to get yourself in trouble. If you don’t have the ability to pay that loan back in 90 days should you lose your job, don’t take the loan. The penalties are too high, as is the cost to your retirement savings: money that ain’t there can’t grow.
Finally, you don’t even NEED this loan. Sure, 4.5 sounds like a great rate and you could save some serious cash. But really, 6% on a 30yr fixed is not going to kill you. (Unless someone kills you to get your really quite good rate.) To consider this a “money-saving” move while you have no emergency savings and no other loan options is just silly. Yes you could get lucky and have it all work out, or you could get just a little bit unlucky and end up in a world of hurt. Seriously not worth it.
Take some time to build up an e-fund and see if your equity recovers at all. Yeah you may lose out on the sweet interest rate, but you may save a lot more down the road.
Ely,
I appreciate your points! However, I still believe the benefit of refinancing to save thousands of dollars more a year far outweigh the concerns that you have.
First, every 401k plan I have seen that offers a loan option only allows you to borrow up to 50% of your account’s balance, or up to a predetermined maximum loan amount (up to $50,000, etc.).
Second, no one’s job is 100% secure for sure. But many professions are substantially more stable than other positions…a nursing job vs. a contruction worker for example. Each family’s situation is different. This is why their is a disclaimer on virtually every personal finance site on the Internet. My goal is to get people to think outside the box a little bit to determine the best possible course of action for their unique circumstances.
Third, for many people, freeing up an extra few hundred dollars a month will go a long way to building an emergency fund quickly, and paying off more debt “down the road”.
Your argument:
This is the same logic behind the third party automobile warranty companies use when they push their expensive warranty contracts. It’s more expensive to do things their way (and your way) and only a slight possibility (in most situations) that it will actually work out better for the consumer.
Refinaning your mortgage using borrowed 401k money is not the answer for everyone, but it “may” be for some…
Hi all,
Here is my input.
300k @ 6% int (p+i) for 30 yrs = $1800.
300k @ 4.5% int (p+i) for 15 yrs = $2300.
15k loan taken from 401k for 3 years (p&i) = $445/mo.
These refinance will result $945 increase in monthly payment for the 1st 3 years of the new loan (4.5% @ 15 yrs fixed) abnd $500 for the reminder of the loan (12 years).
Can you afford that?
My recommendation is that to put as much money you can afford toward the principal at your current loan. If you can afford as much as $945/mo, you dont need to borrow from your 401k and should be able refinance a new 30 years by end of year 1 or pay off your loan faster.
This is my 2 cents…fell free to comment….
Thanks oozze,
Some people may be able to afford that! On the other hand, it looks like lower interest rates on mortgages are here to stay for a while.
You’re right that if you can afford the extra $945 a month payment, you’d be better off saving the difference and then using that money to refinance your house.