Using 401(k) for mortgage payment can worsen plight

PERSONAL FINANCE

November 11, 2007|By EILEEN AMBROSE

You're barely keeping up with the mortgage as it is. Now the interest rate on your adjustable-rate loan is about to reset. Way up.

Casting about for a solution, your eyes fall upon your biggest pot of savings: your 401(k).

Should you go there?

Others have, and benefits experts worry that more will.

Some companies that manage 401(k)s for employers report an increase in loans or hardship withdrawals from plans this year. Principal Financial, for instance, says hardship withdrawals to stave off eviction or foreclosure doubled in August from July.

Baltimore's T. Rowe Price Associates reports a 9 percent increase in loans over a year ago. And Hewitt Associates has seen a "marginal uptick' in loans in recent months.

With loans - unlike hardship withdrawals - workers don't have to say why they want the money. So it's hard to say how many desperate homeowners are using their savings this way.

But David Wray, president of the Profit Sharing/401(k)Council of America, has no doubt that the uptick in loans is tied to the mortgage mess.

Workers are just starting to deal with rate resets on mortgages and home equity loans, Wray says.

It's understandable: For many people, retirement accounts are their only significant savings. Besides, retirement may seem like a long way off while the mortgage payment is due now.

The last resort

But dipping into retirement accounts should be the last resort. Even then, do it only if you're sure that your housing troubles are short-term. If they're not, you could end up losing your house and your retirement.

Employers don't have to allow loans or withdrawals. Many do, figuring that workers wouldn't contribute to a 401(k) if they couldn't touch their money until retirement. But companies and Uncle Sam purposely don't make it easy.

When loans are permitted, you can borrow up to half the balance but no more than $50,000. You generally get five years to repay through payroll deductions. You also must pay interest, often the prime rate plus 1 percentage point, according to Hewitt.

Leave or lose your job before the loan is repaid, and you might have to repay it immediately. If you can't, the loan is considered a distribution. You will owe regular income tax on the money and possibly a 10 percent penalty for early withdrawal. (The penalty usually applies if you take money out before age 59 1/2 , but the age limit is 55 if you're leaving your employer.)

A hardship withdrawal is a more drastic move.

To qualify, you must meet one of a limited number of conditions, such as trying to fend off foreclosure. You will owe taxes and potentially an early withdrawal penalty. The withdrawal is limited to the amount needed to relieve the hardship plus any taxes and penalties, says Stuart Ritter, a Price financial planner.

Loans are better than withdrawals. Still, don't be fooled into thinking loans are harmless because you pay yourself interest.

Consider this example from Price: A 35-year-old worker with $30,000 in a 401(k) borrows $10,000. He stops contributing to the plan while repaying the loan over five years at a 7 percent interest rate. His investments earn 8 percent a year. At 65, he will have $576,595 in his account. But that's nearly $145,000 less than if he didn't borrow at all.

Other things to try

There are plenty of things to try before dipping into your 401(k). Contact your lender or loan servicer at the first hint of trouble. Cut your spending - drop cable, the gym membership and, yes, quit smoking. Take a second job. Take in a boarder. Borrow from relatives.

Just don't get in the habit of putting your mortgage payment on credit cards. That's even worse.

"That's like jumping down a very dark well. There isn't a way out," says Jim Ludwick, a financial planner in Odenton.

Borrowing from the 401(k) could be the solution if you've exhausted better alternatives. But that's only if your mortgage troubles are temporary, and not one of those situations where you bought more house than you can afford.

Ludwick has advised clients to borrow from a 401(k) in cases where they have high credit-card debt and rising mortgage payments. The loan is used to pay off card debt, which then frees up money to handle increasing mortgage payments. So you don't sacrifice your future for the house, continue contributing the same amount of money to the 401(k) on top of repaying the loan, he says.

This only works, of course, if you don't rack up more card debt.

With so much at stake, you need to be honest with yourself about how severe your problem is. Can a 401(k) loan bring a permanent fix? Or is it just a Band-Aid?

"If we borrow from our 401(k), what happens three years from now?" says Barry Glassman, a financial planner in McLean, Va. "If it's just instead of owing money on the mortgage, people owe money to the 401(k), too, it just compounds the problem."

In that case, you might have to face the hard truth: If your income for the foreseeable future isn't enough to pay the mortgage payment, you may just need to sell the house,

"If the ongoing income for the foreseeable future is not enough to sustain the obligation of the house, you need to take a hard look about selling," Glassman says.

Questions? Comments? Want to share your own financial tips with readers? Contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose@baltsun.com.

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