Dear Dr. Don,
I just refinanced a $65,000 10-year mortgage at 6% with a refi at 2.6% over 10 years with $14,000 cash out. Closing costs were $2,660.
I am interested in putting $10,000 in my 401(k) tax-deferred account at a guaranteed 4.2% yield for at least the next 5 years. What do you think?
— Bert Buoyant
If you were a student in 1 of my classes, I’d give you an “A” for the day! This is good news. You have reduced your interest expense on the outstanding loan balance by more than half. Double bonus: Using the cash to invest in a tax-deferred retirement account is providing you with a yield that’s higher than the mortgage rate.
Let’s see the evidence
The table below shows how the cash-out refinancing has lower total interest expense, even after accounting for the higher loan amount and closing costs. This presumes you have 10 years and $65,000 remaining on your existing 6% fixed-rate mortgage.
Advantages of a cash-out refi
|Existing mortgage||Cash-out first mortgage||Difference|
|Loan amount||Existing mortgage: $65,000||Cash-out first mortgage: $79,000||Difference: $14,000|
|Interest rate||Existing mortgage: 6%||Cash-out first mortgage: 2.6%||Difference: -3.4%|
|Loan term (months)||Existing mortgage: 120||Cash-out first mortgage: 120|
|Payment (amortized)||Existing mortgage: $721.63||Cash-out first mortgage: $748.33||Difference: $26.70|
|Total interest expense (pretax)||Existing mortgage: $21,595.99||Cash-out first mortgage: $10,799.61||Difference: -$10,796.38|
|Estimated closing costs||Cash-out first mortgage: $ 2,500||Difference: $2,500|
|Total financing costs (pretax)||Existing mortgage: $21,595.99||Cash-out first mortgage: $13,299.61||Difference: -$8,296.38|
Gauging the pay out later
Homeowners typically aren’t comfortable borrowing against the equity in their home to invest in the market. But you’re planning to lock in a yield on your investments that’s higher than the effective interest rate on your mortgage. It’s hard to say what the after-tax yield will be on the investment because you’re putting the money into a tax-deferred retirement account, and the money won’t be taxed until you take distributions.
Generally speaking, you can’t just throw money into a 401(k) because those contributions are deferred-wage income. But you can ramp up your 401(k) contributions and use the $10,000 from the cash-out to cover your living expenses. If your employer matches all or part of this additional contribution, you’re that much further ahead.
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