The era of low mortgage rates is over. Is there anything that you can do to protect yourself?
Well, before you act please make sure you understand what you are trying to accomplish.
Remember, just because rates are going up doesn’t mean you MUST lock in your mortgage if you are in an adjustable.
Let’s say you have a 2% adjustable rate mortgage and it’s a 5/1 ARM. That means after five years the rate can increase by 1% a year until it caps out at your maximum. So the most your rate could increase in year six is to 3%.
3% is still significantly lower than the 4.61% 30 yr fixed that are out there now. Why would you give up that rate to lock in a higher rate?
Even say in the following year your rate increases to 4%. That is still significantly below where rates are today.
So, after 7 years you’ve paid well below market rates on your mortgage. Guess what. The first 8-10 years is when you really pay your interest too.
Look at your amortization table. Notice the interest is a HUGE part of the overall payment.
After 8 years , you’d need to really think if it makes any sense to refinance now that the bulk of your interest has already been paid.
How about if you were thinking about buying a home. Should you rush in now to lock something in before the rates go highter?
NO! Don’t do that! You see as rates increase, prices could decrease simply due to the fact higher rates makes certainly house price points less affordable. What does that do? Decreases demand.
It’s absolutely fine to borrow from your 401k, especially if you have expensive debt!
In the video below, we actual model the results of two scenarios: 1. Borrow $10k from the 401k to pay off $10k credit card. 2. Don’t borrow $10k from 401k to pay off $10k credit card.
We’ll call the guy in scenario 1, Josh, and the guy in scenario 2, Joey.
401ks and Credit Cards They both have an expected rate of return on their 401k of 6%. They also both paying 10% interest on their credit card.
Josh says to Joey he is going to borrow from his 401k to pay off that credit card. Joey, having read seemingly ALL of the financial literature, says that’s crazy, and he will continue to pay the credit card debt with monthly payments.
When Josh took out the 401k loan the interest rate he paid was 4.5%. He also has to pay the loan back over 5 years, 60 months, meaning his monthly payment was $188
Joey paid the exact $188 a month towards his credit card.
Who do you think came out ahead???
More in 401k Well, unsurprisingly, it was JOSH. Why? Simple, the 4.25% interest he is paying on the loan goes back to HIM! Also, each $188 monthly payment is growing at the expected rate of return of 6% as well.
Josh took out $10k to pay off $10k in debt and paid $11,280 back..100% of which went back to his account. On top of that, that $11,280 was also growing at 6%. Thus over that 60 month time frame, the $11,280 he paid back grew to $13,177!
At the end of 5 years his total account was worth $67,070.
After 5 Years Still a Credit Card Balance! Joey, however, decided to leave his 401k untouched and instead directed his $188 a month payment towards his credit card. Unfortunately for him, after 5 years, he still had a balance of nearly $2,000 on his credit card!
Plus, while he started with more than Josh, after 5 years his 401k only grew to about $67,000 while Josh had a bit more in his account, EVEN after taking the $10k loan!
Ultimately, Josh was nearly $2,000 wealthier than Joey after borrowing from his 401k to pay off his credit card debt.
Will this scenario ring true always??? Of course not.
Investment Returns vs. Credit Card Interest If your expected rate of return is higher than your credit card interest, well, you may want to reconsider. (I’d simply ask how you expect to get that return though???)
Maybe you have a 0% teaser rate on your credit card. My default is to pay down debt, but I get the arbitrage opportunity that exists by using a 0% card and allowing your investments to grow.
Leaving Your Job? What if you leave your job BEFORE the 401k loan is paid off? Then you’ will pay ordinary income (OI) tax on the remaining balance of the loan, PLUS if you’re under 59.5 you’ll also pay a 10% penalty.
So, again, proceed with caution. But don’t simply just follow the herd blindly over the cliff and close your eyes to the opportunity that does exist.
Can’t Borrow Against An IRA Now, you can NOT borrow against an IRA. So, if you have an IRA and are considering taking a distribution to pay off a debt, remember, PLEASE, that each dollar you do take out will be taxed as OI AND if you’re under 59.5 you’re going to pay that 10% IRS penalty.
In this case it will take more than a $15,000 distribution from an IRA for someone who is say 50 years old in a 25% tax bracket to net the $10k to pay the credit card.
Don’t do that!
Taxable Account With Long Term Capital Gains? On the other hand, what if you have a TAXABLE account with some gains in it. Should you use that? Maybe.
Say you have an account worth $10k that consists of $5k of long term capital gains.
Well, in this case you’d pay $750 in a one-time capital gains tax to avoid the 10% interest charge, EACH YEAR!
Makes sense to me to do that. But each situation is different. So, choose your path carefully.
Finally, the best solution of course is to not have any debt! But that’s a tough pill to swallow for most Americans today. Things just cost more than the cash we have available.
Getting Out Of Debt Is Best Solution Going forward though TRY to get out of debt. That is the best financial planning move you can make.