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Better to pay down mortgage or 401K loan?

Discussion in 'General Discussion | Finance' started by heavenlyjane, Aug 1, 2017.

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  1. heavenlyjane

    heavenlyjane Level 2 Member

    We have a spare $1000 at the end of each month. I am comfortable with our existing financial cushion and would like to use this windfall to pay down our final two debts.

    Is it better to pay down a 401K loan, which has 3 years of payments left in it? Or to make an extra payment to our mortgage principle? I'd love both loans to be gone but it seems to me that I should pay down the 401K first because it doesn't have an tax advantages attached to it. My husband needs some persuasion and I need reassurance that my logic is sound.

    Input, please? Thanks.
     
  2. knick1959

    knick1959 Level 2 Member

    This is an excellent question, for which I don't have any kind of a final educated answer. I AM anxious to see what others say. However, when we took loan money from our 401ks to purchase our latest home, it WAS pointed out that all interest you pay is to yourself back into your 401k account. Not so with the mortgage. While the mortgage interest in tax deductible, you're still paying 60-70% (??) to the bank for them to keep.

    If it were me, I'd do the mortgage. Now let's see if I would be wrong :). Although, thinking about it, I did NOT follow my own advice as we rushed to replace the 401k money as a priority. Hmmmm.

    Another thought - the money on loan from your 401k doesn't move with the market. If the market goes up this missing money doesn't. As long as it's on an up-tick, you're losing some gain.
     
  3. heavenlyjane

    heavenlyjane Level 2 Member

    It's not that simple. The money that is tied up in a 401K loan is not free to grow as part of the investment gains. The interest on our 401K loan is 2.125% but we could earn more than that in the mutual funds that our 401K invests in.

    This math is beyond me, and I am generally good at story problems.

    By the way, we took that 401K loan to pay off the last of our share of our kids' student loans. That was a no-brainer to us.
     
    Last edited: Aug 1, 2017
  4. Matt

    Matt Administrator Staff Member

    There's no perfect answer. The situation is basically:

    Should you take a guaranteed rate of X% vs a non guaranteed rate of perhaps Y%.

    Here you've decided to make the nice hypothetical rate 5%. Since your mortgage is likely around 4%, and has tax advantages making closer to 3%, the 5% is a better choice.

    But if your actual rate of return from the 401(k) is 1% (or negative) then you'd be better of in the mortgage.

    Personally, I almost always argue to pay of the mortgage first, because if you are borrowing money to invest in stocks, that's risky. (this is where people think they are borrowing for a house, but really, they are borrowing for stocks or a house, and they choose stocks)

    The important point to remember is that it doesn't really matter all that much. If we're talking $15K of 401(k) and $1K of additional income, the total upside on either the mortgage or the loan is limited to small amount. What does matter is that you've managed to control things to a point where you have an additional $1K per month in cash, which is a great thing, and that you are trying to do the right thing with it.

    • Personally I would say mortgage
    • But also, do the 401(k) and then when it is paid off, snowball the payment onto your $1K and pay the mortgage then.
    • But also, split it between each 50/50

    All options are good.
     
  5. gr8t.2b.free

    gr8t.2b.free Level 2 Member

    Do you know the terms of your 401K loan? If you needed to leave your current job or, God forbid, lose your current job, would you owe the balance of the loan immediately? If that is true, as it is with many loans against job-related retirement vehicles, I would most definitely pay the 401K loan off first.

    If the above is not the case, you might consider which loan has the smallest balance. According to your post, it seems that is your 401K loan. Pay down the loan with the smaller balance then roll that + $1000 extra into paying off your mortgage. It is not a new concept, debt snowballing, but in my experience it fueled motivation to strive even harder to become debt free. Paying off the 401K loan may not seem to be the best financial move when considering interest rates, tax sheltering and more. However, paying OFF a loan may produce synergistic effects impacting behaviors that may result in more improved financial status in the long run.

    There are no words to explain how wonderful it feels to be debt free including a mortgage. Keep up the good work HeavenlyJane!
     
  6. GetawaysRus

    GetawaysRus Level 2 Member

    Another vote for paying the mortgage rather than the 401K loan. The stock market is not 100% reliable, and one of these days it's going to fall. That 2.125% interest on the 401K loan that you are paying to yourself may look awfully good when the stock market hits a downdraft. If there were a 10-20% correction in the stock market, you could then reevaluate whether to pay down the 401K loan or the mortgage.

    Also to consider: is the 401K loan an equity loan against your home? My 401K plan allows that (and it sounds like yours does not). A few years ago, when I needed some cash, I took a loan from the 401K and secured it against my home. So I was borrowing money from myself, paying interest to myself, and deducting that interest on my income taxes. Pretty sweet deal.

    Another thing to think about: depending on the interest rate on your home loan, your Federal tax bracket, and your state income tax bracket, would it be better to put that extra $1000 into muni bonds. I am very near retirement. A few years ago, my wife and I discussed this issue. We had a 2.875% 15 year fixed home loan with about 5 years to go if we continued making the minimum required monthly payment. The home loan was of course a tax deduction. I live in California where state income taxes are high. I felt that we would be financially better off to put extra funds into California muni bonds rather than paying down the mortgage. At the time, I would have been able to earn nearly 3% tax free on high quality California muni bonds while keeping the tax deduction on our 2.875% home loan. My wife preferred to use extra cash to accelerate our home loan payments so that we would get the loan paid off quickly. Her argument was that she preferred the psychological security of having the home paid off, especially if there were some unexpected expense or illness in the future. I have been married for many years, so I understand certain things about marriage. In other words, I let her win the argument and our home is now paid off.

    (As an aside: there is one amusing downside to having your home fully paid off if you are into MS. When I sign up for a new credit card, the application asks for my income and then asks for the monthly payment on our mortgage. Sometimes the application websites have some trouble if I put down that our monthly note is zero.)
     
  7. AnyNameYouWish

    AnyNameYouWish Level 2 Member

    Yeah I think your mortgage rate matters. Ours is fixed 2.79. There wouldn't be much difference between the two if we had that loan. So if the options were just those two I'd probably go with the one that had the lowest balance like previously mentioned.
     
  8. HariOm

    HariOm Transcendent Level

    Another factor: do you think your income tax rate will change during the next three years? If your tax rate will go up it may be best to repay the 401k ASAP. Here's why: 401k loans get taxed twice. You contributed to the 401k with pre-tax money, that will ultimately get taxed when you make withdrawals in retirement (or after age 59.5). However, you are repaying the loan with after-tax money, that is, the net income on your paycheck; income that's already been taxed. So if you repay the loan when your income tax is lowest, that would at least mitigate the net cost. Obviously this might be hard to determine but if for example you thought a big raise or promotion might be coming in the next 36 months it might be optimal to repay the 401k ASAP.
     
  9. Matt

    Matt Administrator Staff Member

    Doesn't really matter. The double tax stuff applies to the interest element. If you have a $15000 loan at say, 5% then we are talking $750 of annual interest. Changing the underlying tax rate on that amount of money isn't going to do anything worth noting.
     
  10. HariOm

    HariOm Transcendent Level

    If you borrow $15,000 of untaxed income and repay that principal using after-tax income, wouldn't it require you to earn gross income well in excess of $15,000 in order to make a $15,000 net loan payment?
     
  11. heavenlyjane

    heavenlyjane Level 2 Member

    Our tax rate may well go up in the next few years. My husband will start getting social security and RMDs on his 401Ks.
     
  12. HariOm

    HariOm Transcendent Level

    So he's turning 70.5... just a thought, can he roll over the 401k into an IRA without paying back the loan? Or maybe the unrepaid loan balance could count toward RMD? Not necessarily advising this, just looking at all the angles like we do with MS. (Remember MS?) It might be worth a perusal of the 401k plan document if it would save some money. Of course if he's happy in the 401k and doesn't want to roll to an IRA, that's different. Just trying to see different perspectives.
     
  13. Matt

    Matt Administrator Staff Member

    Yes, but I don't think that it is relevant. The logic you are suggesting is that at a lower tax bracket you keep more of every dollar. This is sound logic. The part where it loses relevancy is that you suggest allocating these 'higher value dollars' to the 401(k) being better than anything else.

    IE what I'm suggesting is that if you pay the loan in a 40% bracket and then later, when the bracket lowers to 20% you spend that dollar on the mortgage or savings, or something, it is a wash when you compare it to doing the inverse, and waiting for your dollar to be more valuable, and in the interim period using it for mortgage/savings/other.

    It all comes down to the principal repayment (not the interest element) of the loan repayment not being doubly taxed, and therefore possessing the same characteristics of any other investment, with a rate of return which can be calculated and compared.
     
  14. HariOm

    HariOm Transcendent Level

    Maybe it's just semantics, but if you earn, let's say, $19,000 gross, which after taxes results in $15,000, and you use that $15,000 to repay a 401k loan, and then later when you withdraw that $15,000 from the 401k it is treated as gross income which after taxes results in $12,000, that to me seems like the principal repayment is being doubly taxed.
     
  15. Matt

    Matt Administrator Staff Member

    It's not. It's a tricky topic that has confused many people, including CFP's when explaining it.

    Here's an example of how it works: https://thefinancebuff.com/401k-loan-double-taxation-myth.html
     
  16. HariOm

    HariOm Transcendent Level

    Got it. Helpful article. Moment of clarity for me came in the author's comments: "The interest you pay on any other loan (car, credit card) is with after-tax dollars. The earnings your traditional 401k make from any other sources will be taxable at the time of withdrawal. The two taxes are unrelated. You have to pay these two taxes anyway if you didn’t borrow from your 401k."
     
  17. Zip

    Zip New Member

    I think the answer depends on how comfortable you would be to pay off the remaining balance of the 401k loan if it was called. I recently went through an unexpected change of ownership at my employer and we are getting new 401k plans that will not allow the loans to roll over. A few co-workers could potentially be in some trouble. I know someone else and their employer cancelled the plan without notice, leaving her in a higher tax bracket when she couldn't pay back the loan.

    The risk of falling into a higher tax bracket without warning could easily outweighs the marginal benefits of extra mortgage payments for many people.
     
  18. heavenlyjane

    heavenlyjane Level 2 Member

    Wow, that stinks.

    Our 401K loan is actually a TSP loan fr0m my husband's government employer so I think we're fine.

    We ended up deciding to pay down the mortgage by an extra $1000 per month.
     

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