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Paying off your mortgage would be like a dream come true for most people. Not only would this mean owning your home outright, but it could also mean freeing up $1,000 or more of your monthly budget to do whatever you want with it. How great would that be?
One day, my friend Andrew thought he had found “the way”. He told me he had a plan for how he was going to pay off the remainder of his $200,000 mortgage: Drain his 401k account.
What was my buddy’s logic? From his perspective, retirement was such a long way from now. We were both in our early 30’s, so there’d be plenty of time to work and replenish his 401k.
Plus, with all of the money he was going to save from not having a mortgage anymore, Andrew figured that he could bump his monthly contributions up by $1,000 every month to make up the difference.
On top of that, the economy was slowly recovering from the Great Recession of 2008 where the market had dropped by nearly half. “Why mess around gambling with stocks,” he said, “when paying off your mortgage is a sure thing?”
I’ve got to applaud my friend for his ambition. His heart was in the right place, but unfortunately, there were a few things that he wasn’t taking into consideration …
Penalties and Higher Taxes
The first thing you have to remember about taking money out of your 401k before age 59-1/2 is that unless the reason for the withdrawal meets one of the strict IRS hardship requirements, you’ll have to pay a 10% penalty.
In Andrew’s case, that would mean he’d get hit with a huge $20,000 automatic fee just for using this option.
But then it doesn’t end there. Because the money in a traditional 401k has never been taxed, a withdrawal would also trigger a tax payment.
This wouldn’t just be at your normal tax rate. Since the amount that you withdraw gets added on top of your normal income for the year, you’d quickly be pushed into someplace you don’t want to be – a higher tax bracket!
Currently, Andrew and his wife were in the 22% tax bracket (earning about $150,000 per year). But with this $200,000 withdrawal also counting as taxable income, they’d now find themselves in the 32% tax bracket.
Paying taxes on these savings is bad enough. But having to pay almost 10% more just because of the timing of the withdrawal is even worse!
Unless you’d like to pay a hefty 10% penalty and a higher tax rate than you usually do, your 401k is not a piggy bank that you’ll want to raid.
Sacrificing Future Returns
One of the biggest things Andrew was neglecting about his current 401k balance was its potential for future growth.
Yes, the Great Recession had been a very difficult time for the economy. But as time went on, the markets cycled upward and regained value; just like many other times throughout history.
It’s important to remember that when it comes to our retirement savings, one of the best forces we have working to our benefit is the power of compound interest. That’s the money that grows on top of the money you’ve earned.
Because of the way compound interest works, there’s a huge difference between the two scenarios Andrew was considering:
- Leaving his $200,000 right where it is in his 401k.
- Emptying his account and trying to make up the difference with $1,000 monthly contributions over the next 30 years.
Leaving the Money in His 401k
Let’s assume Andrew did nothing and left his $200,000 in the 401k. That means on Day 1 of this example, he starts with a balance of $200,000.
Now let’s assume Andrew is invested in a stock market index fund that produces a long-term average rate of roughly 10% per year. That means in 30 years his $200,000 would be worth:
Making $1,000 Monthly Contributions
Surely making $1,000 contributions every month for the next 30 years is the better option, right? After all, that’s $360,000 in just contributions – nearly double what you originally withdrew.
Unfortunately, wrong! Because Andrew would be effectively starting with an account balance of $0 and slowly rebuilding it over the next 30 years, the effects of compound interest wouldn’t be nearly as powerful.
Investing in exactly the same stock market index fund with 10% annual returns, after 30 years, this strategy would only yield:
That’s a staggering $1,229,393 potential difference!
You can’t go back and make up lost time. The best way to invest for growth is to leave your savings right where it is and let the magic of compound interest do its work!
Finally, the last point that my friend Andrew wasn’t getting was that having money in your home is not the same thing as having money available to spend.
What do I mean by this? I asked Andrew to consider what would happen if there was an emergency like an accident to his home or a medical procedure where money was needed immediately.
Unfortunately, your house is an illiquid asset. Yes, it has value. But it's not something you can readily tap for cash; at least not without getting a special home equity loan from the bank.
Even then, consider what would happen if the emergency was that of a fire, flood, or storm that had damaged part of your home. What do you think the chances of getting a home equity loan would be then?
By contrast, it's going to be far easier to make a withdrawal from one of your retirement accounts. In fact, many of these emergencies qualify for hardship withdrawals meaning you wouldn’t have to pay the 10% penalty.
In a true emergency, you can’t rely on your home as a potential source of income. Having funds available in your retirement accounts is a far better contingency plan.
The Bottom Line
By the end, Andrew was pretty well convinced that maybe draining his 401k to pay off his mortgage wasn’t such a good idea after all. Again, he had great intentions. However, the numbers just weren’t in his favor.
When it comes to your retirement savings, the best thing you can do is try not to get too creative. Leave your nest egg alone and let compound interest do its thing. Check your accounts a few times per year but only to make minor adjustments and ensure that everything is on track.
If you’d really like to accelerate paying off your mortgage as quickly as possible, there are dozens of other ways to accomplish this. Here are some great tips that you can start using today.
Contributor’s opinions are their own. Always do your own due diligence before investing.