Author Topic: Wanting to pay off mortgage, but still be tax efficient.  (Read 10797 times)

BenDarDunDat

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Wanting to pay off mortgage, but still be tax efficient.
« on: May 31, 2012, 12:08:40 PM »
I owe $130K on our mortgage. It's a 30 year mortgage at 4.62%. I have cash funds that total $80K and a salary of around $80k.
A redditor wisely told me, I'd do better to reduce my income using 401K to 71K. Saving myself 10% in income taxes. So, I'm upping my contributions to minimize my income taxes.

If I take a loan on my 401K, added with current savings, combined with a small tax free loan from a relative, we would be able to totally pay off our mortgage. The 401K loan would be at 4.5%, which is a respectable yield on half my 401k. Since I wouldn't be paying 4.62% interest, my effective yield would be 9.12%.

This seems to be a way to both minimize my taxes, and still payoff my mortgage in a relatively short time. Resulting in an extra $6 per year of interest savings.

It seems the downside is minimum. While I could be giving up some potential gains, I'm also increasing my guaranteed gains since the interest rate on my cash savings suck and have sucked for quite awhile now.

I posted this on reddit/personalfinance. I thought I was onto something, but the folks there are 100% against me so far. I'm posting here, hoping that everyone will agree with what I already want to do. I kid. I kid. Honest opinions only please.

smedleyb

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #1 on: May 31, 2012, 12:29:50 PM »
Is this a 401K plan through work?  If so, what are the conditions of the loan payback?

JohnGalt

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #2 on: May 31, 2012, 12:36:49 PM »
I don't think you're getting an effective yield of 9.12%... The 4.5% on the 401k loan would be you paying interest to yourself, and you would be contributing post-tax money back into the 401k to boot, so I don't think this is a very tax effective strategy.

My advice - (unless you have some other reason left out of the post for wanting the mortgage paid off now) if you just plan on keeping the $80K in a cash fund - put it (less whatever you feel you need in reserves) towards the principal on the mortgage.  Max out your 401k contributions (should be $16,000 or so that you can put in per year).  Max out IRA.  Put any extra towards the paying off the mortgage early.

The most tax efficient option of all though would be to invest the $80k in something other than a cash fund and keep the low interest mortgage as the mortgage interest is tax deductible, making it's effective rate lower than what you should expect in returns from investing in the market (granted there is risk involved in the market and potential only opportunity cost as risk in putting the $80K towards the mortgage).




gecko10x

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #3 on: May 31, 2012, 12:43:45 PM »
There are two separate things going on here: lowering your tax rate by contributing more to your 401k, and essentially privatizing your mortgage at the same rate, thereby paying yourself the interest. Definitely do the first. Do the second IF you are comfortable no longer having access to your 401k funds and paying off the mortgage early is a primary goal.

That's my quick assessment.

gecko10x

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #4 on: May 31, 2012, 12:48:48 PM »
invest the $80k in something other than a cash fund

This is probably the best thing to do IMO. You should easily be able to return more than 4.5% annually in the market- I'd say a 7% return would be a good conservative estimate, unless you are super risk-averse.

KittyWrestler

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #5 on: May 31, 2012, 12:55:49 PM »
Don't forget, if you ever leave your job or get canned, you must pay back that loan, otherwise, you face penalty.
I don't think it is wise to take on such risk..

skyrefuge

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #6 on: May 31, 2012, 01:19:57 PM »
The 401K loan would be at 4.5%, which is a respectable yield on half my 401k. Since I wouldn't be paying 4.62% interest, my effective yield would be 9.12%.

The fact that you wrote this, and then repeatedly wrote it in the reddit thread even after people explained you were wrong, tells me that you don't know enough about finances yet to even consider doing something like this.

Say I have $12k in Bank Account A, and $12k in Bank Account B.  I move all the money out of B into A, and then over 12 months, make $2000 transfers each month from A back into B.  That leaves me with twice as much money in B as when I started, so by your math you would say that I got a 100% return on that money (woo hoo, and I thought a 1% APR was pretty great for a bank account!)  But did I?  Hell no, because that "return" was provided by other money that I already had!  Money that you transfer from one source to another is not "yield"!

If I was you, I would read mrzulu's "napkin math" post at reddit where he shows how you would actually LOSE $19k by doing this rather than just paying down your mortgage normally (and that doesn't even consider the other risks), and figure out how his math/assumptions are wrong.
« Last Edit: May 31, 2012, 01:21:38 PM by skyrefuge »

BenDarDunDat

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #7 on: May 31, 2012, 01:49:40 PM »
I don't think you're getting an effective yield of 9.12%... The 4.5% on the 401k loan would be you paying interest to yourself, and you would be contributing post-tax money back into the 401k to boot, so I don't think this is a very tax effective strategy.


Okay, my math was messed up on the 9.12%. Now, help me understand the bit about post-tax money.

My 401K is pretax. So I'm lending myself the funds at pretax amount. Now, I'm paying those off with post tax dollars, but I'm going to be paying my mortgage with post tax dollars whatever the case.

BenDarDunDat

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #8 on: May 31, 2012, 02:03:20 PM »
The 401K loan would be at 4.5%, which is a respectable yield on half my 401k. Since I wouldn't be paying 4.62% interest, my effective yield would be 9.12%.

The fact that you wrote this, and then repeatedly wrote it in the reddit thread even after people explained you were wrong, tells me that you don't know enough about finances yet to even consider doing something like this.

Say I have $12k in Bank Account A, and $12k in Bank Account B.  I move all the money out of B into A, and then over 12 months, make $2000 transfers each month from A back into B.  That leaves me with twice as much money in B as when I started, so by your math you would say that I got a 100% return on that money (woo hoo, and I thought a 1% APR was pretty great for a bank account!)  But did I?  Hell no, because that "return" was provided by other money that I already had!  Money that you transfer from one source to another is not "yield"!

If I was you, I would read mrzulu's "napkin math" post at reddit where he shows how you would actually LOSE $19k by doing this rather than just paying down your mortgage normally (and that doesn't even consider the other risks), and figure out how his math/assumptions are wrong.

MMM is not r/personal finance, so I imagine I could be given yet another point of view.

I was 100% incorrect on my yield, but the other reply's 'back of the envelope math' doesn't account for the fact that the vast majority of funds used to pay off the mortgage will be cash currently drawing around 1.4% interest and it also assumes 8% yield in the market...which after the last 13 years, I'm not so certain that's a given. But using those assumptions, increasing my yield on 80K from 1.5% to 4.5% ...and then considering the 45K having a potential yield of -3.5% is still an increase in yield for me.

Beat me up over any assumptions I have that are in error. I'm aware that this goes against conventional wisdom, and most times it's better to ride in the pack. Though I'm arguing these points, I haven't decided one way or the other. I definitely have much that I can learn, especially when it comes to taxes.  I still think it was wise to post in both places.

AJ

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #9 on: May 31, 2012, 02:11:42 PM »
The most tax efficient option of all though would be to invest the $80k in something other than a cash fund and keep the low interest mortgage as the mortgage interest is tax deductible, making it's effective rate lower than what you should expect in returns from investing in the market (granted there is risk involved in the market and potential only opportunity cost as risk in putting the $80K towards the mortgage).

This.

There are two separate things going on here: lowering your tax rate by contributing more to your 401k, and essentially privatizing your mortgage at the same rate, thereby paying yourself the interest. Definitely do the first. Do the second IF you are comfortable no longer having access to your 401k funds and paying off the mortgage early is a primary goal.

And this.

I think you are right to up the 401k contributions to reduce your tax burden. But I don't think you should borrow the money to pay the mortgage. While mathematically the best option would be to keep the mortgage and invest the $80k, if that is too risky for your taste you could put the $80k toward the mortgage, then just pay it down with cashflow. It doesn't have to be all or nothing, and it sounds like you could pay it down rather quickly with your income.

JohnGalt

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #10 on: May 31, 2012, 02:14:14 PM »
I don't think you're getting an effective yield of 9.12%... The 4.5% on the 401k loan would be you paying interest to yourself, and you would be contributing post-tax money back into the 401k to boot, so I don't think this is a very tax effective strategy.


Okay, my math was messed up on the 9.12%. Now, help me understand the bit about post-tax money.

My 401K is pretax. So I'm lending myself the funds at pretax amount. Now, I'm paying those off with post tax dollars, but I'm going to be paying my mortgage with post tax dollars whatever the case.

True - I guess that part may wash out.  I guess the 401k part really comes down to - do you think the investments inside of your 401k will perform better or worse than the interest rate on your mortgage.  Keeping in mind, that the mortgage interest is tax deductible and the earnings in the 401k are tax deferred.  Unless you are extremely risk averse in your investing strategy within your 401k, I don't see how it can make mathematical sense to borrow from the 401k to pay off the mortgage.

skyrefuge

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #11 on: May 31, 2012, 02:32:56 PM »
I was 100% incorrect on my yield, but the other reply's 'back of the envelope math' doesn't account for the fact that the vast majority of funds used to pay off the mortgage will be cash currently drawing around 1.4% interest and it also assumes 8% yield in the market...which after the last 13 years, I'm not so certain that's a given. But using those assumptions, increasing my yield on 80K from 1.5% to 4.5% ...and then considering the 45K having a potential yield of -3.5% is still an increase in yield for me.

I think you're muddying things up a bit by combining lumping different transactions together.  Let's look at the $80k cash.  Yes, paying that into the mortgage gets you a "return" of 4.62%, which is definitely better than the 1.5% you're currently getting.  Is that 4.62% better than if you invested that 80k elsewhere?  Maybe, maybe not.  Many here would say that you could expect to beat that return in the stock market, and I tend to agree with them.  But, I still went against that logic a few months ago and took $83k that I had in a bank account earning 1.25% (funny how similar the numbers are) and paid off my 5.75% mortgage (ok, that number is less-similar!)  So yeah, totally put the 80k towards your mortgage if you think that's a better/more-guaranteed return than you can get in the market.

Then, taking out a loan from your 401(k) to repay a loan is a totally separate topic.  You can scale the numbers in mrzulu's example down to whatever they actually are for you; it was wrong for me to repeat his loss of $19K as an absolute figure when he was assuming a $100k 401(k) loan.

In general, I think when examining the two loans in isolation, it just becomes a matter of comparing the rate of one to the rate of the other.  You'd essentially be taking out a 4.5% loan to repay a 4.62% loan.  Sure, that would save you a few bucks, but at the cost of losing out on any return the money would have gotten if it stayed in your 401(k).  If you can manage to get any return above 0.12% on the money in your 401(k), then you'd lose money by taking out the loan.  Even if your 401(k) returned 0%, that 0.12% of "savings" wouldn't be worth the risk of having to immediately repay the full balance of the loan if you lost your job.  And if your mortgage interest is at all deductible, that probably would more than make up the 0.12 point difference in rate even assuming 0% investment gain.

Finally, does your 401(k) plan allow you to simultaneously make loan repayments while also making pre-tax contributions?  I assume so, but it's something to consider because locking yourself out of pre-tax contributions would make things even worse.
« Last Edit: May 31, 2012, 02:43:00 PM by skyrefuge »

BenDarDunDat

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #12 on: May 31, 2012, 02:52:51 PM »
I was 100% incorrect on my yield, but the other reply's 'back of the envelope math' doesn't account for the fact that the vast majority of funds used to pay off the mortgage will be cash currently drawing around 1.4% interest and it also assumes 8% yield in the market...which after the last 13 years, I'm not so certain that's a given. But using those assumptions, increasing my yield on 80K from 1.5% to 4.5% ...and then considering the 45K having a potential yield of -3.5% is still an increase in yield for me.

I think you're muddying things up a bit by combining lumping different transactions together.  Let's look at the $80k cash.  Yes, paying that into the mortgage gets you a "return" of 4.62%, which is definitely better than the 1.5% you're currently getting.  Is that 4.62% better than if you invested that 80k elsewhere?  Maybe, maybe not.  Many here would say that you could expect to beat that return in the stock market, and I tend to agree with them.  But, I still went against that logic a few months ago and took $83k that I had in a bank account earning 1.25% (funny how similar the numbers are) and paid off my 5.75% mortgage (ok, that number is less-similar!)  So yeah, totally put the 80k towards your mortgage if you think that's a better/more-guaranteed return than you can get in the market.

Then, taking out a loan from your 401(k) to repay a loan is a totally separate topic.  You can scale the numbers in mrzulu's example down to whatever they actually are for you; it was wrong for me to repeat his loss of $19K as an absolute figure when he was assuming a $100k 401(k) loan.

In general, I think when examining the two loans in isolation, it just becomes a matter of comparing the rate of one to the rate of the other.  You'd essentially be taking out a 4.5% loan to repay a 4.62% loan.  Sure, that would save you a few bucks, but at the cost of losing out on any return the money would have gotten if it stayed in your 401(k).  If you can manage to get any return above 0.12% on the money in your 401(k), then you'd lose money by taking out the loan.  Even if your 401(k) returned 0%, that 0.12% of "savings" wouldn't be worth the risk of having to immediately repay the full balance of the loan if you lost your job.  And if your mortgage interest is at all deductible, that probably would more than make up the 0.12 point difference in rate even assuming 0% investment gain.

Finally, does your 401(k) plan allow you to simultaneously make loan repayments while also making pre-tax contributions?  I assume so, but it's something to consider because locking yourself out of pre-tax contributions would make things even worse.

Yes, I can continue to make pre-tax contributions to 401k while also making loan repayments.

I'm over 40, so I am not 100% invested in stock in my 401k.  A percentage is invested in bonds and government issues.  Most people would advise me to have a mix of risky and less risky investments. It seems to me that the 4.62% for a secure investment would be encouraged if I were investing in a bond, but most appear to automatically discourage it when it is a loan.

BenDarDunDat

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #13 on: May 31, 2012, 03:11:04 PM »
The most tax efficient option of all though would be to invest the $80k in something other than a cash fund and keep the low interest mortgage as the mortgage interest is tax deductible, making it's effective rate lower than what you should expect in returns from investing in the market (granted there is risk involved in the market and potential only opportunity cost as risk in putting the $80K towards the mortgage).

This.

There are two separate things going on here: lowering your tax rate by contributing more to your 401k, and essentially privatizing your mortgage at the same rate, thereby paying yourself the interest. Definitely do the first. Do the second IF you are comfortable no longer having access to your 401k funds and paying off the mortgage early is a primary goal.

And this.

I think you are right to up the 401k contributions to reduce your tax burden. But I don't think you should borrow the money to pay the mortgage. While mathematically the best option would be to keep the mortgage and invest the $80k, if that is too risky for your taste you could put the $80k toward the mortgage, then just pay it down with cashflow. It doesn't have to be all or nothing, and it sounds like you could pay it down rather quickly with your income.

We are hovering near a market high. I've seen my account balances up where I think I'll be retiring in a few years multiple times only to watch them crash to the ground. That 80K is not keeping up with inflation, so I NEED to do something with it. But it is incredibly difficult to find good safe yield right now. While there is an opportunity cost with committing the funds to my mortgage, I'm still getting a very good yield on the funds by escaping the 4.62% I'm paying on my mortgage.

You are correct, and it doesn't have to be all or nothing. It's a lot to think about.

BenDarDunDat

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #14 on: May 31, 2012, 03:20:04 PM »
Also of note, I've upped my 401K contribution due to tax bracket advice, so I'm adding 17K per year. This is going to prevent me from paying down my mortgage as quickly as I'd like. This 401k loan is kind of a round'a bout way of paying it off and I'd have 40K added back in just over 2 year...not even considering the 2 years worth of loan repayments.


menorman

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #15 on: May 31, 2012, 03:42:12 PM »
It seems here that there isn't a clear goal. Would you like to be mortgage-free? Do you want to retire early? Are you trying to lower your tax rate? How those questions are answered would help determine the course of action. Clearly, your $80k is losing value to inflation, so you'd like to save that. However, if an early retirement is what you seek, stuffing all the money into a 401k may not be your #1 choice either, especially if you could eliminate a major recurring expense by paying off the mortgage. So a definitive look at what the goal is could be helpful in getting advice.

skyrefuge

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #16 on: May 31, 2012, 04:03:41 PM »
Also of note, I've upped my 401K contribution due to tax bracket advice, so I'm adding 17K per year. This is going to prevent me from paying down my mortgage as quickly as I'd like. This 401k loan is kind of a round'a bout way of paying it off and I'd have 40K added back in just over 2 year...not even considering the 2 years worth of loan repayments.

Again, you're muddying the picture by merging two independent things.  Keep 'em separate!  So I think we have at least three independent actions you want to take:

1) Do something different with your $80k, either pay down mortgage, or invest: good idea either way!
2) Max out your 401(k) pre-tax contributions: good idea!
3) Take out 401(k) loan: bad idea.

If you're maxing out your 401(k) pre-tax contributions, that means you're contributing $1417/mo. from your paycheck.  Great.  You'll be doing that regardless of whether you take out a 401(k) loan or not.  You cannot think of those $40k contributions in 2+ years as "making up for the loan", because you would be making those same contributions even if you didn't take out the loan.

Then you'll have to take another amount of money from your paycheck (I dunno, $1500?), post-tax, to pay off a loan.  That loan could either be your original mortgage, or a 401(k) loan.   Since the interest rates on the loans are so similar, there's really no advantage to the 401(k) loan over your mortgage.  And the disadvantages are that you'll lose potential returns on the 401(k) money loaned, you could be taxed and penalized if you lose your job, and your interest isn't deductible on the 401(k) loan.  So it seems obvious to just stay with your mortgage.

gooki

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #17 on: May 31, 2012, 04:23:41 PM »
+1 stay with the mortgage, but put as much after tax disposable income towards paying it off. It'll be gone in 18 months or so.

sol

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #18 on: May 31, 2012, 08:57:14 PM »
I don't see any value in increasing 401k contributions so you can take out a loan against your 401k to pay down debt, unless the interest rate on the 401k loan is significantly better than the mortgage rate after tax deductions.  Since mortgage interest gets favorable tax treatment, this seems unlikely to pencil out unless you have a crappy mortgage.


BenDarDunDat

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #19 on: May 31, 2012, 09:26:27 PM »
I don't see any value in increasing 401k contributions so you can take out a loan against your 401k to pay down debt, unless the interest rate on the 401k loan is significantly better than the mortgage rate after tax deductions.  Since mortgage interest gets favorable tax treatment, this seems unlikely to pencil out unless you have a crappy mortgage.

I'm increasing my 401k contributions because anything earned over 71K is taxed at 25% instead of approx 15%. However, doing so prevents me from really attacking my mortgage since it removes 17K from my available cash flow. However, by doing a loan from my 401k, I can get around that detail and free up nearly 50K to attack mortgage and interest payments.

sol

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #20 on: May 31, 2012, 10:40:58 PM »
I'm increasing my 401k contributions because anything earned over 71K is taxed at 25% instead of approx 15%. However, doing so prevents me from really attacking my mortgage since it removes 17K from my available cash flow.

Okay, this feels like one of those Do The Math situations.

Figure out how much money you expect to save in taxes by increasing your 401k contributions.  It's likely not as much as you think, because you're only deferring taxes by using your 401k, not actually saving them.

Then figure out how much money you would save over the remaining term by applying that same amount to your mortgage.  Compare this to the tax savings from step one, times the remaining years of your mortgage over which you would do it.

That will tell you whether it makes more sense to up your 401k or apply the cash to your mortgage.  Then for the next round, separately consider the values of taking out a 401k loan.  In that case, you'd be comparing the money saved by immediately paying off the mortgage with the money spent to finance the 401k loan. 

This is going to involve playing with mortgage and 401k-loan amortization calculators to figure costs, and estimating your tax bite in retirement when you withdraw your 401k. 

Sounds like an interesting excel spreadsheet assignment, but one that definitely has a "correct" answer for someone with the patience to work it out.  Asking for advice here or anywhere else is never going to be as useful as running the numbers yourself.

skyrefuge

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #21 on: May 31, 2012, 11:49:51 PM »
Then for the next round, separately consider the values of taking out a 401k loan.  In that case, you'd be comparing the money saved by immediately paying off the mortgage with the money spent to finance the 401k loan.

I did this part, after realizing I was somewhat wrong (I think!) in my previous posts where I said there was essentially no advantage to the 401(k) loan.  I forgot that the advantage is that the interest you pay on the 401(k) loan remains as part of your net worth, while the interest you pay on your mortgage vanishes into the ether.  I think these numbers are pretty close to BDDD's, except I'm guessing at his payoff rate.  In both cases, we first pay down the existing mortgage (using the $80k cash), leaving a $50k mortgage balance.

Case 1:
======
- Don't touch the $50k in 401(k)
- Pay off remaining mortgage balance in 36 months from income stream
- At 4.62%, paying off that $50k is 36 payments of $1490.03, amounting to $53641 ($50k in principal and $3641 in interest).

Case 2:
======
- Take $50k out of 401(k) at 4.5% and pay off mortgage.
- Pay off 401(k) loan in 36 months from income stream
- At 4.5%, paying off that $50k is 36 payments of $1487.35, amounting to $53545, all of which eventually is contributed to the 401(k)

Assuming 7% return (that's a number MMM uses, and we're at his site, so that seems appropriate), in Case 1 the 401(k) balance ends at $61252 after 3 years (started at $50k and made no contributions).  In Case 2, it ends at $59556 (started at $0k and made $1487.35/mo contributions).  If you also contributed the extra $2.68/mo you have left free in Case 2 due to the slight interest rate difference, you finish with $59663.  So Case 1 wins by $1589.

But our OP seems to be much more pessimistic and risk-averse than MMM.  So if we instead assume a 0% return over 3 years, Case 1 ends right where it started with $50000, while Case 2 ends with $53641.  Then Case 2 wins by $3641 (that's the amount of the interest payments which otherwise would have gone to the bank).

The break-even point seems to come at about a 5% return, where both cases end with about $57880 in the 401(k).

The relatively small amount of interest payments on that balance+term means that the max tax savings due to the mortgage interest deduction would be about $300 over those 3 years, and only if he's already at or above the standard deduction.  But it's still a slight push towards Case 1.

And I would still be concerned about Case 2 and the tax/penalties if I lost my job and had to repay the 401(k) loan in 60 days.  All that adds up to say that for me, I'd wouldn't risk the 401(k) loan; if returns end up being above 5%, I've lost money doing it (especially since those returns continue to compound), and I'd lose more money if I lost my job.  But your expected rate-of-return still means that different people can have different answers.

BenDarDunDat

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #22 on: June 01, 2012, 08:02:21 AM »
Gross Income        Data     Current    Current   Payoff all    Payoff All Payoff PartPayoff Part
Yrly Interest paid   -6144   -18000   -18000   0           0          -7200   -7200
401K 50%            41000     9000   0           6000   6000   9000   0
401k 50%            41000     9000   0           9000   0            9000   0
Cash savings            80000     3400   3400   11000   11000   11000   11000
Yrly free cashflow   15000     25000   0            25000   0            25000   0
                                        28400   -14600    51000    17000    46800   3800
                                         7%    0%             7%           0%             7%            0%
When you drop the yield to 7%, taking the loan of the 401K is an even better option. Using cash only for a partial payoff yields less, though there's extra security. However, if the market doesn't increase over that time, the total payoff results in in an $13000 difference

In the event of an emergency, we have a house that we own with plenty of equity and credit cards.

skyrefuge

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #23 on: June 01, 2012, 10:56:07 AM »
I have no idea how to interpret this table, or even how to interpret the conclusions you drew from it.  If you care to explain it at all, I'm strangely obsessed with this odd mission, so I'm happy to check your math/assumptions, but at this point I don't even know where to start.  Are your figures "yearly", or cumulative over a number of years?  It seems like some might be yearly and some are 3-year cumulative?  I'm thinking that the "9000" in the second column is the 3-year return at 7% on the "41000" in the first column, and the "3400" is the 3-year return at 1.5% on the "80000"?  But then what is the "11000" in the "Payoff" columns?  And what is the "Yrly free cashflow" line, and why is it 25000 for the 7% columns and 0 for the 0% lines? 

Also, to fix your table formatting, wrap it in |code| |/code| tags (highlight the table and click the "#" icon above the message box).

grantmeaname

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #24 on: June 01, 2012, 11:04:19 AM »
You could also open a google docs spreadsheet, share it, and post the link on the forum. Then we could all see the formulas and figure out how the two of you came to different conclusions.

BenDarDunDat

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skyrefuge

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Re: Wanting to pay off mortgage, but still be tax efficient.
« Reply #26 on: June 03, 2012, 07:34:52 PM »
That helped a little, but I still don't know what a lot of the figures are, especially the ones in the "cash savings" and "yearly free after tax" rows.

So I went way overboard and made a spreadsheet that actually performs all the calculations when you enter your starting assumptions:

https://drive.google.com/previewtemplate?id=0AtRUuOv4p1LkdEhGV2VPSEZTZ01Qc01fVFcwYlBxLUE&mode=public

It's a Google Docs Template, so click the "Use this template" button to make a local copy and enter all your data into the yellow boxes in the top section.  Then on the bottom, the left side shows the result if you leave your 401(k) money where it is, and the right side shows the result if you take a loan from your 401(k).  Your monthly cashflow must be equal to or greater than the monthly loan payments you have to make, whether it's the mortgage payment or the 401(k) loan payment (or both, the spreadsheet allows both to exist simultaneously if you want).  If your required loan payments are less than that cashflow level in a particular scenario for a particular month, that excess cashflow is assumed to be invested in your 401(k) (or similar investment vehicle) and then growing at the rate-of-return you enter.

The ending result compares the difference in value in your 401(k) at the end of the time period (which is the same length for both scenarios).  This is essentially comparing your "net worth", because the only difference between your net worth in each scenario will be due to the difference in your investment accounts. 

You should be able to achieve all of your Current/Payoff All/Payoff Part scenarios simply by adjusting the various inputs.

By playing around with inputs, it reveals that it essentially comes down to the same basic tradeoff of paying off your mortgage early vs. using that cash to invest; the 401(k) loan has little effect.  If your assumed rate-of-return is greater than your mortgage rate, paying the mortgage off as slowly as possible (not taking a 401(k) loan) wins.  And if your return is less than your mortgage rate, paying it off quickly by taking out a 401(k) loan usually wins.  If you don't take out the 401(k) loan, you lose money to interest payments on the mortgage, but if you *do* take out the 401(k) loan, you lose money having that money out of the market where it can grow.

For these calculations I ignore the mortgage interest tax-deduction, but I include the total mortgage interest paid over the remaining life of the loan, so you can roughly calculate it yourself if it applies.

I discovered that the "interest rate" on the 401(k) loan is essentially irrelevant, and doesn't affect the calculations at all.  As the rate goes up, all it does is require a greater monthly payment into your 401(k).  But the only way you could accept a loan at that higher rate is if you had free monthly income large enough to cover the larger payment.  And if you have that free monthly income, you would be directing it to your 401(k) (or similar investment) anyway, so all an increased rate does is it makes that extra monthly investment mandatory rather than voluntary.

In the end, I still advise against the 401(k) loan.  You still face the risk of tax+penalty if you lose your job, and the only cases where the 401(k)-loan scenario wins by enough to consider accepting that risk is if you know that your investment return will be well below historical averages, and that sounds like market-timing to me.