How to boost 401(k) with a cash-out refi

Don TaylorDear 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

Smiling man working on his computer © iStock

Dear Bert,
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 mortgageCash-out first mortgageDifference
Loan amountExisting mortgage: $65,000Cash-out first mortgage: $79,000Difference: $14,000
Interest rateExisting mortgage: 6%Cash-out first mortgage: 2.6%Difference: -3.4%
Loan term (months)Existing mortgage: 120Cash-out first mortgage: 120
Payment (amortized)Existing mortgage: $721.63Cash-out first mortgage: $748.33Difference: $26.70
Total interest expense (pretax)Existing mortgage: $21,595.99Cash-out first mortgage: $10,799.61Difference: -$10,796.38
Estimated closing costsCash-out first mortgage: $ 2,500Difference: $2,500
Total financing costs (pretax)Existing mortgage: $21,595.99Cash-out first mortgage: $13,299.61Difference: -$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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