401(k) is poor source of refinance funds

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Dear Dr. Don,
A year or so ago, my 401(k) account was worth $265,000. Now it is worth $134,000. My mortgage balance is $289,000, while the home’s value — at least according to Zillow.com — is now about $275,000. I have a 5/1 interest-only adjustable-rate mortgage at 5.5 percent with its first interest rate reset in August 2010. I am 62 years old.

Here’s my dilemma: I am concerned about where interest rates will or could be by August 2010, but refinancing appears to be out of reach because my loan-to-value ratio is lousy. I was considering taking my 401(k) money, paying the 20 percent federal and 5 percent state income taxes and putting the remaining $100,000 onto my current mortgage. That would put me in a better position to refinance, hopefully at an interest rate under 5 percent. Help!
— John Jump-start

Dear John,
I’m not going to give you “carte blanche” to empty out your retirement account to pay down your mortgage so you can qualify to refinance. You want to preserve a measure of financial flexibility, and liquidating your 401(k) doesn’t work toward that goal.

You’ll also want to rethink what your marginal federal income tax rate would be if you had a tax year with an extra $134,000 in income. Twenty percent mandatory withholding on the distribution doesn’t mean you will owe 20 percent in federal income taxes. Talk to your tax professional to get the particulars.

It’s important to know the provisions of your existing loan. A 5/1 interest-only ARM will typically convert to a fully amortizing loan at the time of the first reset, so you would expect your payment to increase, even if the interest rate did not because of the principal component included in the payment. Bankrate’s “Interest-only ARM calculator” can show you the expected jump in payment. Refinancing at a lower rate will allow you to extend the loan term, reducing the monthly payment.

You know the first reset date, but what interest rate is used as the base rate for the loan, and what is the pricing spread? Is there a maximum amount that the interest rate can increase in a single reset? How about a lifetime cap? Is there a floor that the interest rate can’t fall below? You can track most of the interest rates used in pricing adjustable-rate loans on Bankrate using the “Rate Watch: Track leading interest rates” pages.

With any refinancing decision, it’s important to estimate how long you expect to be in the house. If you don’t plan on staying in the house for long, it’s harder to justify taking on the costs of refinancing. You’d be better off shouldering the interest rate risk over the short term. The Mortgage Professor has a refinancing calculator, “Refinancing an ARM into an FRM,” that can help with that decision.

If refinancing looks like it makes sense for you, I’m going to suggest you first take a look at the government’s Making Home Affordable Web site and see if you qualify for a refinance.

The site states as one of the provisions, “You may be eligible if your first mortgage does not exceed 125 percent of the current market value of your home.” That way, you don’t have to raid your retirement monies to become eligible to refinance your home.

Read more Dr. Don columns for additional personal finance advice.

Read more about refinancing a mortgage loan.