One of the dreaded costs in buying a new home is the prospect of paying private mortgage insurance. Generally if your down payment is less than 20 percent of the sale price, your lender will require you to get mortgage insurance. A mortgage insurance policy protects the lender in case you default on the payments. As a borrower, you pay the premiums, and the lender is the beneficiary. Good deal for the lender, not so good a deal for you, especially because PMI can run 0.5% to 1.0% of the loan value per year. For a loan of $500,000 that is between $2,500 – $5,000 per year!
Most homeowners try to eliminate PMI as soon as possible. The standard advice is to keep track of your payments on the principal of the mortgage. When you reach the point where the loan-to-value ratio hits 80 percent, you should notify the lender that it is time to discontinue the PMI premiums. Federal law requires lenders to tell the buyer at closing how many years and months it will take for them to reach that 80 percent level and cancel PMI. Lenders must automatically cancel PMI when the balance hits 78 percent.
But there is another way to go about it. A recent client had a home that was valued at $620,000 and had a $523,992 mortgage. So they need to to reduce the mortgage by at least $28,000 in order to get under the 80% level. Their PMI was over $300/month.
When I created their balance sheet, I discovered they had well over $165,000 in 401k plan assets. And most important, the 401k plan with the vast majority of assets allowed the owner to take a loan against the balance.
My advice was simple. Take out a 401k plan loan in an amount to get the mortgage balance below the 80% level. Payback the loan using the same amount as the former PMI payment. By doing so, the mortgage will be prepaid, because the 401k loan is applied to the outstanding mortgage balance. At the end of the repayment period, the 401k balance will be back to where it was before the loan (assuming everything else is held constant) and several years of repayment will be cut off from a 30-year mortgage loan.
Now you may be saying this is crazy, don’t take about a loan against retirement! Indeed Bankrate.com has an article that begins with the following sentence “Taking out a 401(k) loan is like cutting off your own limb. Most advisers would call it an act of fiscal insanity, unless you’re genuinely trapped with no other financial lifeline available.” They offer four general tips for the use of 401k loans, but really no practical advice.
In this situation, however, paying off PMI through a loan to yourself makes total financial sense because you will be eliminating a substantial payment that provides no value to you while at the same time prepaying your mortgage. Nonetheless, I have two caveats with this advice:
First, make sure you like your employer. Often if you leave your employer, you have a short period of time (say 60 days) to repay the 401k loan. So make sure you plan on staying with the employer for the duration of the repayment period.
Second, you need to rebalance your remaining investments in the 401k. The standard advice against a 401k loan is that interest you save by choosing a 401(k) loan over a bank loan still might not be enough to make up for your loss of earnings from taking the money out of your 401k plan. But this argument is a red herring. You often pay yourself back at a low interest rate. In other words, the loan amount is now in a low-interest bearing investment but still in your retirement account. To get around this potential loss of earnings, reallocate your remaining account to be more aggressive. For example, if you have a 401k balance of $150,000 and it is an 80% stock / 20% bond allocation and you take $30,000 from it, you will have $120,000 left after the loan. Remember your total balance is still $150,000 because you will repay the $30,000 that you just borrowed. So with the remaining, $120,000 put it all in stocks (80% of $150,000 = $120,000) since the $30,000 that is in the loan is earning only a low-interest rate (e.g., a bond or money market fund). At the end of the repayment period, you will be back to the original allocation. So if you reallocate your remaining portfolio to make it more aggressive , you won’t lose any earnings.
Look into using 401k loan to eliminate your PMI if you are in the unfortunate position of paying it now. It may save you lots of money over the long-term!