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 401(k) plan to pay down the difference.
Most experts agree that borrowing from your 401(k) 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 homeowners are underwater and want to refinance, lenders usually require them to bring money to the table to pay down the difference so the property’s value fully covers the loan.
What Is LTV and Why It Matters if You’re Underwater
If you’re underwater on your mortgage — meaning you owe more than your home is worth — your loan-to-value ratio (LTV) is over 100%. LTV is the ratio between your loan amount and your home’s appraised value, and lenders use it to gauge risk during a refinance.
For example, if your home is worth $200,000 but you still owe $240,000 on your mortgage, your LTV is 120%. That’s a red flag to most lenders, because they typically want the new loan to be equal to or less than the home’s value.
Some loan programs allow high LTVs — even up to 95% or 97% — but when your LTV is too high, you may not qualify for a refinance unless you can bring cash to the table to reduce your loan balance. This is known as a cash-in refinance.
In these situations, a 401(k) loan might help. Borrowing from your retirement account could give you the cash you need to get your LTV back into an acceptable range and move forward with the refinance.
Loan Access May Be Available
One of the big benefits of a 401(k) 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.
Borrowing from your 401(k) is often straightforward, but not all plans allow loans. You’ll need to check with your plan administrator, and the rules — including how much you can borrow and how long you have to repay — can vary.
The catch is that if you don’t repay the loan on time — or if you leave your job and can’t repay it quickly — the remaining balance may be treated as a taxable distribution and subject to a 10% early withdrawal penalty if you’re under age 59½.
Interest rates on 401(k) loans are usually set by your plan and are often based on the prime rate plus 1% or 2%, though the exact rate depends on your employer’s plan terms.
The other key thing to remember is that while you’re repaying a loan, you’re really repaying yourself. All repayments — including interest — go back into your 401(k) account. However, it’s important to note that you’re repaying the loan with after-tax dollars and will still owe income taxes when you eventually withdraw the funds in retirement, meaning you’ll be taxed twice on that money.
Your 401(k) as a Multiplier
The advantage is that taking a relatively small amount out of your 401(k) may enable you to refinance a 5-to-10-times larger mortgage. In some cases, the monthly savings from refinancing your mortgage could outweigh the potential gains your 401(k) loan would have earned in the market, but this depends on many factors, including interest rates, investment performance, and how long you plan to stay in the home.
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 401(k). 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, your monthly payment will be $1,089. You will save $411 each month, but because you extended the term by five years, your total interest savings will be 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 401(k) 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% interest would require a monthly payment of approximately $475, 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 you still need to come up with $475 a month 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 401(k) 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 in 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.
Programs for Underwater Borrowers
Although some government-backed refinance programs like HIRO and FMERR helped underwater borrowers in the past, these specific programs are no longer active. If your mortgage is backed by Fannie Mae, Freddie Mac, the FHA, VA, or USDA, contact your loan servicer to ask about current options.
Some lenders may still offer high-LTV refinancing on a case-by-case basis, especially if your payment history is strong.
Final Thoughts
A 401(k) loan isn’t the right move for everyone, but in some situations, it can help unlock a refinance that improves your monthly cash flow and long-term financial outlook. Just be sure to weigh the trade-offs carefully — and consider speaking with a lender or financial advisor before tapping your retirement funds.
