Detrming Whether a Second Mortgage is Cheaper Than a 401k
A Home Buying Article Contributed by Robert Scalia
Taking out a Second Mortgage Versus Pulling the Funds from Your 401k
Picture this second mortgage scenario.
You need 10,000 dollars for home improvements, given that you've decided to finally go ahead and redo your entire bathroom. Your mortgage broker has advised you that you have two available options at you disposal to come up with the money: You can either take out a second mortgage or borrow from your 401K retirement fund.
But before you make a decision, you need to figure out whether or not the tax benefits derived from the second mortgage loan would outweigh the advantage of borrowing from your own 401K money.
Here are a few simple rules you can follow to ensure you make the right decision.
A Couple of Basic Rules When Thinking out Your Second Mortgage Option.
Remember that both the second mortgage and 401K options have tax benefits.
The rule is that you borrow at the lowest after-tax cost. For a second mortgage, the after-tax cost is usually calculated by taking the interest rate and subtracting the tax savings. You can calculate this by multiplying the interest rate by 1 minus your tax rate.
The cost of borrowing from your 401K, on the other hand, is not the rate you charge yourself, the reason being that what you are simply doing is taking the money from one pocket and putting it in another. Therefore, the cost is what your loan would have earned had you kept the money in the 401K. In economics, this is always referred to as the "opportunity cost".
Once you have calculated each, the rule is simple: If your 401K has been earning more than the after-tax cost of the second mortgage, the opportunity cost of borrowing from your 401K is higher than the cost of the second mortgage. So that's not the way to go.
Taking a Second Mortgage Example to Drive the Point Home
If a borrower needs $10,000 and is looking at a second mortgage, he must know that he will have accumulated $100,000 in his or her 401K earning with 10% interest per year.
The rate on his home second mortgage, on the other hand, might be 8.5%. Since the 10% cost of borrowing from the 401K is higher than the 6.12% cost of the second mortgage, it stands to reason that the borrow should probably go with the second mortgage.
However, there is also another reason why it's not always a good idea to borrow against 401K account.
If the borrower is laid off, for example, the loan must be repaid within a month or two. If this doesn't happen in the allotted time, the IRS will consider this to be a taxable distribution on income taxes. that would ultimately mean that 10% early withdrawal penalty would be due.
Failure to repay a second mortgage, on the other hand, can also result in the loss of the home. So the borrower should consider both risks before reaching a decision.
