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treerootCO
08-19-2008, 09:04 AM
--Thinking beyond the norm here so the usual thought process does not apply--

If someone had enough money in their 401K to pay off their house in full, including paying the penalty for early withdrawal with the assumption that the hardship rules cannot be applied, would the math work out in that person's favor? At 7% APR, we pay the majority of our monthly payment to interest and a minimum to principal. Assuming that the house is paid and taxes/insurance are the only expense that needs to me covered, that would allow 100% of the mortgage payment to be applied to a 401K (15,500 max per year) and the remainder could be funneled into an IRA to replenish the nest egg.

Discuss....

Mendocino
08-19-2008, 09:06 AM
How old are you and how much longer do you plan on working?

Romer
08-19-2008, 09:14 AM
I don't think that would be the best use of the money. If you make under the threshold and are thinking of withdrawing the 401K, I would look into a ROTH as all the money you make going forward would be tax free, and you can withdraw the money later if you need it. Don't rob your future to pay something off now. Hard to think about for younger folks.

treerootCO
08-19-2008, 09:15 AM
How old are you and how much longer do you plan on working?
31 years young and plan on retiring in 2010.:lmao:

Retirement goal of 67.

Uncle Ben
08-19-2008, 09:19 AM
A lot of unanswered variables to just say yay or nay. How many payments are left on the home? You would probably come out ahead if you paid 1.5 or double house payments for the rest of the term. the .5 or full extra payment would go directly to principle and you would see the house loan disappear shockingly fast! The other problem besides penalties on pulling the 401 before maturity is the interest earned will most likely no longer fall under a tax deferred status meaning it will become an income. Lot's of issues to research!

Uncle Ben
08-19-2008, 09:21 AM
I don't think that would be the best use of the money. If you make under the threshold and are thinking of withdrawing the 401K, I would look into a ROTH as all the money you make going forward would be tax free, and you can withdraw the money later if you need it. Don't rob your future to pay something off now. Hard to think about for younger folks.

x2 on ROTH's Great investment if you let them work!

RockRunner
08-19-2008, 10:35 AM
Don't forget the tax implications, you will loose your house interest. We did 1.5 payments for a while and got killed on our taxes.

My vote, keep the money and increase your payments if you want. If something were to happen you have your 401 or Roth, selling or getting a loan on the house may proof to be difficult in time of need.

Red_Chili
08-19-2008, 10:50 AM
If you ever choose to get another loan, only the interest on the first 100K is deductible too. Or so my accountant tells me.

Right now you are looking at a real buying opportunity in equities. Depending on your retirement investments, you could make many times more than what you save here rather shortly (5 year time frame).

At your age, keep your money working. And don't skimp on health insurance, O weld-without-helmet one!

nakman
08-19-2008, 11:42 AM
Don't forget the tax implications, you will loose your house interest. We did 1.5 payments for a while and got killed on our taxes.



Tom, how were your interest payments any different? All you did was throw extra $$ at principle right? Your payments were still based on the P+I of your amortization schedule, you just increased the P... what am I missing :confused:


As for 401k question, I'd probably side with the "keep it" guys. Unless your principle was < $50K then I could see doing a 401K loan to pay it off, since you'd then get all the interest, not just 40% of it back. Typical 401K loan rules are up to $50K, or half the account, payable up to 5 years at 1+prime.

Red_Chili
08-19-2008, 12:47 PM
As for 401k question, I'd probably side with the "keep it" guys. Unless your principle was < $50K then I could see doing a 401K loan to pay it off, since you'd then get all the interest, not just 40% of it back. Typical 401K loan rules are up to $50K, or half the account, payable up to 5 years at 1+prime.
A year ago, that would have been a deft move. You would have saved some losses and essentially kept the money AND the borrowing cost - which could have been used to purchase equities NOW (or relatively soon at least). Double dipping. Now, you would be taking money out of equities at a bad time. That makes the opportunity cost of payoff a whole lot more than 1+prime (which I admit is pretty much like increasing your 401K contribution).

On the other hand, timing the market is pretty hard to succeed at in the short term. Timing business cycles, broadly speaking at least, is not so much really if you don't mind missing it by half a year.

I guess I'm with Nakman. If it is a small amount, meh. I kinda doubt it is though.

DaveInDenver
08-19-2008, 12:47 PM
Tom, how were your interest payments any different? All you did was throw extra $$ at principle right? Your payments were still based on the P+I of your amortization schedule, you just increased the P... what am I missing :confused:
I was wondering about that, most times that 13th payment is just a 100% principle payment, but the yearly interest is still the same. Well, except that the forward looking interest will go down because the principle is going down. So this year your deductions don't change, but maybe you get less deductions in future tax years?

I've read opinions that say using the interest deduction as justification for keeping a mortgage as being hollow and if you can pay off a house, you should always do it. In the end, the more money you can save and invest rather than using it to pay off debt, the better. But you should also not put yourself into risk by putting all of your savings into the house.
As for 401k question, I'd probably side with the "keep it" guys. Unless your principle was < $50K then I could see doing a 401K loan to pay it off, since you'd then get all the interest, not just 40% of it back. Typical 401K loan rules are up to $50K, or half the account, payable up to 5 years at 1+prime.
That is my thought. You have to weigh the growth of the savings against the loan interest. A $200K loan at 7% over 15 years will be a total value of around $325K. So if the $200K house value goes up 3% per year over 15 years, it'll be worth about $315K. It will cost you about $10K in real money to use the bank's money for 15 years when you sell. If you return 2% per year on that $200K you didn't spend 15 years ago, that savings will be around $275K. But if you invest well and can do 5% per year, that $200K will be $425K after 15 years.

Something like:
Initial house = ($200K)
Future house = $315K
Interest@7% = ($125)
200K@2% = $75K
200K@5% = $225K

So keeping the loan and getting 5% return on $200K will yield you $225K in growth plus the increase value of the house of $115K, minus $125K in interest and you will have $340K in 15 years when you sell the house. Paying off the house and not having that money to invest, after 15 years you will have only made $115K. Even if you only do 2% growth on the $200K, you increase your value by $75K on the saved money, plus $115K in house value, minus the interest of $125K and you are still ahead $65K. So I'm not sure I see the paying off the house argument as long as you actively invest.

Edit: I keep reading that, something doesn't right. Have to keep thinking about this...

The problem is there is no perfect answer. Well, that's not exactly true, the right answer is continue investing and minimizing debt no matter if you pay off the loan or not. But an index fund like a SNXFX will do 3% in a bad year and 7% in a good year. It's all about time. The market since 1998 has grown around 40% and since 1988 it has grown 430%, so stable growth stocks over time are your friend (for example, Exxon is up about 125% over the last 10 years). As the economy grows, so do your investments. You want to keep a mix of income, debt and investment over time. If you put all your money into the house and the value does not grow much, then you are losing ground to inflation. Or so is my thought.

nakman
08-19-2008, 01:17 PM
Well, except that the forward looking interest will go down because the principle is going down. So this year your deductions don't change, but maybe you get less deductions in future tax years?

NFW, really? You think a bank would charge you less interest because you reduced your principle ahead of schedule? I don't buy it, not unless you refinance. but I'm no banker, obviously..

DaveInDenver
08-19-2008, 01:32 PM
NFW, really? You think a bank would charge you less interest because you reduced your principle ahead of schedule? I don't buy it, not unless you refinance. but I'm no banker, obviously..
I dunno, that's the only way I could think of it being an advantage to paying off early. Why would you make extra payments if there's no financial gain? If they are going to charge the same to use their money for 15 years as they do for 30 years, you might as well keep the present cash and buy something useful (beer) or invest the money in something else (brewery stock). Each extra payment must hack off interest at the end of the period, right?

Tch2fly
08-19-2008, 01:45 PM
I'm with Dave but he has too many numbers ;) and many financial planners have moved away from the concept of home ownership as an investment.

$.02 from me.


The value of the home (for argument sake 200k value) will increase or decrease with the market regardless of the amount of debt. Any equity is getting ZERO growth on it's value (only the total value of the home varies).

If you are paying 7% on the mortgage and the value of your 401K investments grow by 10% you still have net growth of 3% not great but growth.

If you pay off the house you have a 200k asset with net growth of zero on the equity. The house value may increase to 250k so then you get 50k but you would get it at closing regardless of the amount of your payoff. So for me it makes very little cents ;)

If you are smart and disciplined enough to re-invest the money that would have gone toward your mortgage payment you will eliminate the interest payment and show growth on the new investment :thumb: BUT you still have200k in equity that shows zero growth :(.

Chris
08-19-2008, 02:15 PM
Don't mess with a K401. You'll give up too much in tax free savings and growth to outweigh the gains especially paying the early withdrawal penalty. Let the K401 grow until you reach retirement and can access it w/o penalty. Then, despite what financial advisors may say, pay the damned mortgage off and have peace of mind.

corsair23
08-19-2008, 02:16 PM
NFW, really? You think a bank would charge you less interest because you reduced your principle ahead of schedule? I don't buy it, not unless you refinance. but I'm no banker, obviously..

I'm sure you've looked at an amortization schedule before for a home loan? The interest is front loaded/biased meaning that your P is small and your I is large at the beginning of the loan. As time goes by the P grows and the I shrinks but it is YEARS before the P becomes larger than the I depending on the length of the loan...

Now, if you "pay ahead" on your loan you theoretically "skip" some of the larger I payments, moving ahead in the amortizaton schedule. The best time IMO to pay ahead is at the beginning of the loan when your P is relatively small and adding in an extra $50, $100, or $200 bucks per month could mean making an extra one, two, three, or even more P payments. Waiting till later in the life of the loan to pay ahead so just means that the P payment is growing thus the extra $$ you throw at the loan doesn't go as far...

Now, the trade off here is that the I portion of your payment by paying ahead is shrinking (possibly by a sizeable amount) because the interest was front loaded. If you itemize your deductions for tax purposes then you effectively reduce your mortgage interest deduction on your taxes therefore more than likely increasing your tax liability as a result. Obviously it isn't a dollar for dollar affect meaning that if you paid $5K less in mortgage interest on year you are going to pay $5K more in taxes that year. But, if you don't compare your year to year deductions and the impact that has on your tax liability it could come as a shock when doing your taxes that you paid so little in mortgage interest that year that your tax liability went up. If you didn't account for that change in withholdings then you either get less of a refund or owe more than you had planned to owe...Still, again in the long run it is $$ in your pocket if you can pay ahead on the mortgage WITHOUT affecting your savings plan for retirement.

We've only lived in our current home for 5 years but I have started to notice a consider difference in the last couple of years after paying ahead on my amortization schedule since day one. I think back when the extra $50-$100 I would throw in each month was paying ahead on the mortgage by 4-6 payments each year. Now that the P on my loan is higher that same $50-$100 each month is more like maybe an extra 2 payments each year.

corsair23
08-19-2008, 02:28 PM
Don't mess with a K401. You'll give up too much in tax free savings and growth to outweigh the gains especially paying the early withdrawal penalty. Let the K401 grow until you reach retirement and can access it w/o penalty. Then, despite what financial advisors may say, pay the damned mortgage off and have peace of mind.

Agreed. At most I would suggest to Mike that for a limited time he reduce or even cease his 401K contributions and use what $$ he was putting into his 401K to pay down the home loan. NEVER go below the amount needed to get a company % match though if where you work has that though because that is basically free $$.

I will say though that doing the above will be a double whammy. First, by not contributing (either at all or at a reduced amount) to your 401K your taxable wages go UP thus so do your Federal and State income taxes. Then, assuming you itemize your deductions for tax purposes and are using the extra $$ that use to go into the 401K to pay down the mortgage, thus reducing your mortgage interest deduction, then your yearly deduction will go DOWN and your tax liability will go UP. So to the 'guvmint you are making more $$ and have less deductions so you should pay more in taxes :(.

Personally, I'd put the max I could (whether by law or by how much you can afford) into the 401K and then if you have some extra $$ left over each month after paying for everything else throw that at the mortgage or open up some additional savings investments....

Nay
08-19-2008, 02:33 PM
Paying off a home is one of the riskiest things you can do in today's financial world where you don't get a pension and social net programs like Social Security are at great risk (I'm 38 and doubt I will ever see a penny - I treat Social Security tax as Federal Income Tax for retirement planning purposes). Back to why not to buy equity:

First off, if the house loses value, your money is gone. Not your equity built through appreciation, your savings. How much do we still hear about the "safe" 30 year fixed loan with 20% down? How is it safe to lose that 20% to declining home values instead of having it in liquid diversified investments than can be cashed out to cover any short term cash requirements, including even having to buy yourself out of your house if you choose to move?

Second, if you want to spend your money, you have to ask a lender's permission based on documented income, credit score, and assets, or you have to sell the home. Lenders are not particularly "giving" in today's markets, nor are houses particularly easy to sell. For zero percent upside, I'd sure want better terms that that.

Third, investing in home equity is a zero percent return that loses value in real terms. You have probably heard somebody in our parents' generation say "I have now paid more for a car than I paid for my first house". That's inflation. In 30 years, the value of the equity you buy in today's dollars will be a fraction of what it is worth today.

But you shouldn't listen to me. You should listen to all of the TV ads pitching reverse mortgages. A reverse mortgage is for a senior homeowner who is house rich and cash poor. A lifetime of an extremely expensive zero percent interest investment has left them trading home value for an annuity based on the equity in their home. I'd hate to be in that position in a market with massively declining home values.

At 31 you are young enough to afford some leverage to grow your financial position. No debt is *good*, but it does serve a purpose at different life stages as long as you are using that debt in order to build a portfolio of diversified assets that will generate income that will both enable retirement and long-term debt payoff.

Ideally we all acquire nothing but income generating assets and use those assets to buy all of those goodies that are truly liabilities financially, but most of us are already at least knee deep, so you have to figure out how to manage growth with the right level of risk for your age. At 31, your investments should not be conservative - you can afford some market swings as you aren't relying on those assets for current income. As you get closer to retirement, that investment mix has to shift to capital preservation - the key is to have capital to preserve, and buying home equity will give you exactly $0 of income generating assets no matter how much you buy.

nakman
08-19-2008, 02:45 PM
I dunno, that's the only way I could think of it being an advantage to paying off early. Why would you make extra payments if there's no financial gain? If they are going to charge the same to use their money for 15 years as they do for 30 years, you might as well keep the present cash and buy something useful (beer) or invest the money in something else (brewery stock). Each extra payment must hack off interest at the end of the period, right?

Ok, so if I make extra payments, I "advance" on the amortization schedule then? So say at month #3 I pay about 3 principles' worth of extra, so I jump from payment #3 to #6 by paying 4 & 5's principle? I always thought it was just throw more at principle, but still make payment #4's interest payment, and the only advantage was a shorter payoff or more cash at closing. But it actually reduces your interest? Interesting...


So Nay what would you say the smartest way to buy a house is today? $325K purchase price, planning on 5 year stay minimum.... do you put 20% down on a 30 year fixed? ARM? interest only and invest the difference in FJ40 parts?


edit: I love these threads, btw, I always learn something.. :o

corsair23
08-19-2008, 05:50 PM
Ok, so if I make extra payments, I "advance" on the amortization schedule then? So say at month #3 I pay about 3 principles' worth of extra, so I jump from payment #3 to #6 by paying 4 & 5's principle? I always thought it was just throw more at principle, but still make payment #4's interest payment, and the only advantage was a shorter payoff or more cash at closing. But it actually reduces your interest? Interesting...

That is how it was explained to me years ago when we bought our first house and I was told to get an amortization schedule from the lender and keep track of where I was...If I'm wrong hopefully someone will correct me :thumb:

I guess now that you mention it I don't know if you necessarily skip those interest payments so much as you shorten the life of the loan? Of course then that would just shorten the end when the I is small and the P is big not saving you much in the way of interest :confused:.

No, I'm still thinking it is the way I described above. Say your payment is $1000 per month. For the first year per the amortization schedule $950 of the montly pymt on average goes toward interest and $50 goes toward the principal. If you are able to pay an extra $50 each month then you are in effect skipping ahead so after the first year you are actually on payment #20 or so (knowing the P continues to go up so gradually that extra $50 doesn't go near as far). Maybe in year two it is more like a $900/$100 split so the extra $50 only covers 1/2 of the principal for a month. And so on.

Now you have my curiousity up to know if that really is the way it works or what I was told was bunk all those years ago. I do recall hearing that some loans are written with prepayment penalty clause for this very reason though.

Romer
08-19-2008, 07:53 PM
Jeff is correct

RockRunner
08-20-2008, 02:04 PM
Ok, so if I make extra payments, I "advance" on the amortization schedule then? So say at month #3 I pay about 3 principles' worth of extra, so I jump from payment #3 to #6 by paying 4 & 5's principle? I always thought it was just throw more at principle, but still make payment #4's interest payment, and the only advantage was a shorter payoff or more cash at closing. But it actually reduces your interest? Interesting...





edit: I love these threads, btw, I always learn something.. :o

Nak,

The interest on your home loan changes every time you make a payment. If you follow your normal payment plan on a $100K loan for 30 yrs here is how it goes,

payment 1 = 599.55 total Payment
99.55 Principle
500.00 Interest

Payment 12 = 599.55 P&I
105.16 P
494.39 I

Payment 60 = 599.55 P&I
133.61 P
465.94 I

Now the same loan but $100 extra per month


Payment 1 = 699.55 P&I
199.55 P
500.00 I

Payment 12 = 699.55 P&I
210.80 P
488.75 I

Payment 60 = 699.55 P&I
284.34 P
415.21 I


Loan paid off in 2029 instead of 2038

30 year normal payment = 115838.19 in interest paid

Same loan paid with extra $100 per month 75937.94

You save $39900.25 in interest only, plus you pay only till 2029

The problem is that you are paying less interest every year you loose that on your tax write off.

I know this is a garbled mess, sorry about that. I am trying to do this while I have a major migraine and under the influence of pills :(

Basically the less interest you pay on your loan the less you can write off. We got nailed several years ago for nearly $4500 extra in taxes because we were paying Bi-monthly. :eek:

Go to this website and play with the numbers, http://www.bankrate.com/brm/popcalc2.asp

RockRunner
08-20-2008, 02:06 PM
I do recall hearing that some loans are written with prepayment penalty clause for this very reason though.

Colorado does not have a prepayment penalty anymore as far as I know. I know when we paid our loan off on the town-home we were worried about that and that is what we were told.

nakman
08-20-2008, 02:32 PM
Ok, so I definitely learned something about interest then, thanks!

treerootCO
08-20-2008, 05:33 PM
U.S.Bank aka Devilbank has early prepayment penalties...DAMHIK

Rock Dog
08-20-2008, 06:16 PM
U.S.Bank aka Devilbank has early prepayment penalties...DAMHIK

I have heard that before, but ask them how much the peanalty really is... in many cases it is less than you might think..

I know people that take the amortization schedule:
Using the previous example of $500 a month.
. Month 1- make the normal first payment of $500.00
-------> Plus the principle of payment 2.
. Month 2- make the normal payment of $500.00
------>. Plus the principle of payment 4.

and so on. The idea is you are generally strapped at first and have more money as time goes on, so you can afford to increase the amount of the amount of the additional monthly payment... Of couese this take effort and disipline, but can also result inthe loan being paid off in half the time.

SteveH
08-21-2008, 08:52 AM
Coming in late to this discussion - on the face of it, this strikes me as a terrible idea. You're considering taking money that's earning 8-12% in your 401(k) (depending on investments), paying a 10% penalty, and paying off a 7% house loan? Your real return is a big negative. That house money borrowed at 7% is the 'cheapest' money you'll ever have on hand.

In an 'iffy' housing market, you may even have a negative return on this 'paid off' house down the road if it loses value.

Also, I don't think anyone has mentioned that houses are extremely illiquid - meaning you can't get the money out quickly if you need it for a true emergency - whereas you can with a 401(k). Yes, you can get a HELOC...

Also, by cashing out your 401(k) while the market is low, you lose the 'dollar cost averaging' advantage in that you're failing to 'sell high' all the stuff you 'bought low'. Don't get out of the market now, for heaven's sake!

I, too, would like the 'warm feeling' of a paid off house - but not at such a high cost.

Just my .02 worth...

Steve

treerootCO
08-21-2008, 09:31 AM
Trying to make sense of all the facts presented...

Home loans differ so everyone is right. You have to ask for the amortization schedule to see what kind of loan you signed up for. Devil Bank gave me a loan that was 100% interest for the first few years. I was naive and payed it off early with a refi and payed the penalty. I paid 400 a month for two years of interest only and then they slapped a few grand on top of that as well as a penalty for closing an checking account I never used so the payoff was 12,000 more than the original loan. Live and learn...

The tax break you get year end is a % of the interest paid. Pay off your house and yes you don't get the tax break but then you didn't pay the interest in the first place so???

The assumption is that the money that would have gone into a mortgage payment is now funneled into a high risk 401K to replenish the money used to pay off the house at 3,000 a month.

The last factor is that all this assumes you have the right to keep your job. If someone lost their job and the house wasn't paid off, they are out. Simple math, you don't pay your mortgage, you are not entitled to keep your home. Some people are lucky and have secure employment. Others may not be able to find a job in this economy should they find themselves unemployed.

I don't want to have to work to survive. If I could pay off a house in full and use the money to buy solar panels, wind powered turbine, septic, well, etc. and not have to rely on others for my basic needs, I could reduce a heck of a lot of stress. Please don't let this turn into a whole 'green' thread because living off the grid makes sense to me..I am not about to go out and buy a Prius as a knee jerk reaction to the media's attempt to brainwash our society.

Red_Chili
08-21-2008, 11:45 AM
The tax break you get year end is a % of the interest paid. Pay off your house and yes you don't get the tax break but then you didn't pay the interest in the first place so???

The assumption is that the money that would have gone into a mortgage payment is now funneled into a high risk 401K to replenish the money used to pay off the house at 3,000 a month.

The assumption is, you pay low interest to use someone else's money, and even get part of that back, to invest the capital in higher return vehicles and grow it a lot faster than if you paid off your mortgage and took the 'house payment' to your 401(k).

That said, you make a fine point about financial security and the anxiety-reducing aspect of having no mortgage and these are the strongest reasons to do it. You are thinking older than you are. Or did you turn 55 when I was not looking? ;)

At this time in your life, it makes more financial sense to follow the first assumption, especially at this time in the business cycle. Bailing on equities now only locks in your losses. You will feel the security but you will be financially set back, and to a considerable degree by the time you turn 60. That would be 'opportunity cost' and those costs compound over time in lost return. Compounded loss is as powerful as compounded earnings.

You could work out the various scenarios on a spreadsheet. That was very helpful in making my decision at least. See which one you like best once you see the bottom line. Weigh it against risk. Make the choice. Don't look back (though revisiting things can be a great idea).

But there is no 'right' decision. There is the decision you feel comfortable making and that is the one you should make.
:thumb:

Chris
08-21-2008, 11:54 AM
I am also a believer in having the financial security and anxiety-free lack of a mortgage but I am over 55. The market fluctuations can drive anyone nuts and finding a quick-fix is not good over the long run.

While I expect to get some disagreement from folks here it's my belief that the next quarter will show significant improvement (yes, election related activity) and bailing now will lock current losses and miss future gains.

Red_Chili
08-21-2008, 12:47 PM
What he said. Not sure if it will be the next quarter (though I will certainly not complain) but the bounce is coming. Inflation is the real worry now, and interest rates will go up as soon as Bernanke sees even the slightest glimmer that he can take away the punchbowl just as the party is starting.