Borrowing from a 401k to Refinance an Underwater Mortgage

Read Time: 4 minutes

Many homeowners underwater on their mortgages search for ways to flip their home finances and dig out from owing more than their home is worth. One possible solution to this is borrowing from a 401k plan to pay down the difference.

Most experts agree that borrowing from your 401k plan is a bad idea. However, when market conditions are right, such as when home values are depressed, and mortgage rates are low, this can be a viable strategy.

In situations where you’re underwater, and you want to refinance, lenders usually require that homeowners bring money to the table to pay down the difference so the property’s value fully covers the loan.

Approval is Automatic

One of the big benefits of a 401k is that if you’ve been paying into it for any length of time, you will probably have enough cash to cover the deficit on your mortgage. Terms vary, but you can often borrow up to half the value of your account and use the money for whatever purpose you want.

Making a withdrawal is easy, and you can’t be denied for any reason because it’s your money. The catch is that you’ll need to pay back the money to your 401k or incur a 10% penalty.

Interest rates on 401k loans are competitive and generally set a few percentage points above the prime rate.

The other key thing to remember is that while you’re repaying a loan, you’re really repaying yourself. The entire repayment, including all the interest, goes back into your 401k.

Your 401k as a Multiplier

The advantage is that taking a relatively small amount out of your 401k may enable you to refinance a 5-10 times larger mortgage. You could find that your savings from refinancing your mortgage are far greater than what that money could earn by staying in your 401k.

The downside is that it’s likely to raise your short-term debt obligations, at least for the next five years, while you pay back your 401k. Also, the money you borrow from your account won’t be able to appreciate tax-free, so if the stock market surges between now and then, you’d miss out on those earnings.

An Example of Possible Savings

Suppose you took out a $250,000 mortgage five years ago at 6% interest on a 30-year loan. Assuming regular monthly payments of $1,500, you’d have that paid down to about $232,000, with 25 years remaining on the loan.

In a down market where your home is underwater, let’s say it is only worth $207,000. However, if you’ve got good credit and can refinance your mortgage at 4.5%, and assuming you have $4,000 in refinance costs, you’ll need to kick in approximately $25,000 to eliminate the negative equity and cover the new loan.

Refinancing $211,000 ($207,000 in value plus $4,000 in closing costs) at 4.5% interest over 25 years results in a monthly payment of $1,173. That reduces your mortgage payment by $327 a month, and you save $77,000 in interest over the life of the loan.

If you decide to refinance for 30 years, it results in a monthly payment of $1,089. You save $411 each month, but because you extended the term by five years, your total interest savings is only $44,000 over the life of the loan.

This does not factor in the $25,000 you borrowed and must pay back to your 401k over the next five years. If you don’t pay it back, there’s a 10% penalty. Paying back $25,000 over 5 years at 5.25 percent interest requires a monthly payment of $475 a month, which is more than what you’d be shaving off your monthly mortgage payment in either of the above scenarios.

It’s money you’re paying back to yourself, but it’s still $475 a month you need to come up with for the next five years.

Terms, market conditions, interest rates, and home appreciation are always in flux. In some cases, you may get a more favorable deal than this example, but sometimes you won’t.

Consider These Factors

A 401k loan is all about the numbers. You’ll need to weigh your options perhaps with the help of a tax professional or an accountant who can guide you through various scenarios.

Some things to pay attention to include:

The amount you want to borrow. The less you need to borrow to cover your underwater shortfall, the easier to meet your repayment obligation.

How long you have left on your current loan.  The longer the period you have left on your current mortgage, the more savings you may realize. Lenders front load mortgage interest payments on the early years of a loan which is why the amount you owe doesn’t fall quickly in the first couple of years on a mortgage.

When you can wipe out those unfavorable terms early in the loan, you can compound savings over a longer timeframe to produce more significant savings.

The difference in interest rates. The bigger the difference between your current interest rate and the rate you can refinance at is a big indicator that you can save more money in the long run. A difference of 2% isn’t as attractive as an interest rate with a 4% difference.

How long you plan to stay in your home. If you’re not planning to live in your home for several more years, refinancing may not be appropriate simply because you won’t be there long enough to save more than the closing costs.

Several Programs Are in Place

Suppose your current mortgage is backed or serviced by government agencies or government-sponsored enterprises like Fannie Mae, Freddie Mac, or others. In that case, programs are in place to help you navigate through an underwater refinance. Some of those include:

  • Fannie High LTV Refinance Option (HIRO).
  • Freddie Mac Enhanced Relief Refinance Mortgage (FMERR).
  • FHA Streamline.
  • VA Interest Rate Reduction Loan (IRRRL)
  • USDA Streamline Direct

Aaron Crowe

Aaron Crowe is a seasoned personal finance and real estate journalist. Aaron writes on real estate as it relates to mortgages, refinancing loans and lending for

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