Should You Pay Off Your Home Mortgage With Your 401K?

July 12, 2018

“My current 401K balance is about the same as my mortgage balance. I am 45. Would it make sense to pay off the mortgage with the 401K?”

Bad idea! Looking ahead to retirement, your objective should be to accumulate a 401K nest egg of financial assets as large as possible, and pay off your mortgage as soon as possible. You should pursue these objectives independently, not sacrifice one to obtain the other. On balance, that would be a loser, for multiple reasons.

Early Withdrawal Costs: Funds withdrawn from a 401K before age 59 1/2 trigger tax payments on the amount withdrawn plus a 10% early withdrawal penalty. While there are exceptions to the withdrawal penalty, paying off a mortgage balance is not one of them. That means that paying off a mortgage balance with a 401K balance of the same amount would not be a break-even but would generate a sizeable cash outflow.

Earnings Opportunity Loss on the Existing 401K Balance: An even larger loss from liquidating your 401K is the future earnings on the funds withdrawn. These earnings accumulate tax free until you are 70 1/2, and at that point you pay taxes only on the amounts withdrawn at your tax bracket at that time – which could be a lot lower than it is now.

Possible Earnings Opportunity Loss on New Contributions: If your intention is to abandon your 401K after it has been depleted, given that  you are still many years from retirement, the largest loss would be the tax-deferred income you could contribute plus the tax-deferred earnings on those contributions that you would be making in future years. Your major objective should be to contribute as much as possible – I have no advice on that – and obtain as high an earnings rate as possible. I do have some thoughts about that.  

Maximizing Earnings on 401K Accounts: Over a period of years, the rate of return on your 401K should be well above your mortgage rate. At 45, you should be invested largely if not entirely in common stock. A diversified portfolio of common stock will generate high rates of return over long periods along with high short-term variability. For example, during the period 1926-2012, the median return on the common stock of large companies over 25-year periods was 11.34%. The highest 25-year return was 17.26% while the lowest was 5.62%. Over 10 year periods within the same time span, the median return was 10.52%, with a high of 21.43% and a low of minus 4.95%.      

As you get closer to the day when you begin drawing funds out of your 401K – say about 10 years before -- you should consider shifting as much as half of your 401K assets into interest-bearing securities. The reason is that the short-term variability in stock returns can be very costly once you enter the drawdown period.

Avoiding 401K Abuses: Not all 401Ks are created equal. Fund sponsors sometimes use them for their own purposes, reducing their value to the account holders. Among the abuses that can contribute to the poor performance of a 401K are inclusion of the common stock of the company sponsoring the 401K as an investment option; long delays in transferring employee contributions to the plan; outright theft of the contributions; high administrative and investment expense ratios, which may reflect services provided to the fund’s sponsor.

Employees with poorly performing 401Ks are not powerless. Help is available from the Employee Benefits Security Administration of the US Department of Labor. In addition, several law firms specialize in class action suits against employers who abuse their 401K programs. They can be found by Googling “401K abuses”.

Paying Down Your Mortgage Balance: Your mortgage balance should be paid off by the time you begin drawing funds from your 401K. If scheduled amortization will not do the job, you should develop an extra payment program that will. Calculator 2a on my web site was designed for that purpose, showing you the schedule of balances remaining for any combination of extra payments and payment intervals.

To maintain the discipline needed for a successful extra payment program, make the payments immediately after being paid. Waiting until the end of the pay period is a recipe for failure.

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