2nd Mortgage or 401K?

When in need of extra cash, many homeowners have wrestled with the question of the best way to get it. Assuming they have built up a decent amount of equity in their home, homeowners have several options in this situation.

They can get a 2nd mortgage, consider a home equity line of credit, or choose a cash-out refinance. These options and more are usually available for borrowers in need of quick cash. In this article, we will examine the choice between getting a 2nd mortgage and “borrowing” from a 401K fund.

Because both options have tax consequences, your tax bracket will be very important in making this decision. You will want to choose the option that gives you the best after-tax result. For this reason, you cannot think solely of the interest rate on the 2nd mortgage you are considering. You must consider the 2nd mortgage’s rate, the rate you are taxed at, and the return you expect on your 401K.

Calculating the after-tax cost of your 2nd mortgage is fairly simple. Multiply the interest rate you would get on the mortgage by one minus your tax rate. After you make this calculation, compare it to the rate of return on your 401K. You need to make this comparison because any money you take out of your 401K will not be earning the same tax-free return it would have if it had remained in the 401K.

For example, assume you need $10,000. Your options are taking out a 2nd mortgage at 8.5 percent or borrowing from your 401K. Further assume that you are in the 28 percent tax bracket, and that your 401 K earns you ten percent each year. Your after-tax cost for the 2nd mortgage is 8.5 times (1 – 0.28), which comes out to 6.12 percent. This is less than the cost of borrowing the $10,000 from your 401K, so the 2nd mortgage would be preferable.

Another, non-monetary factor that leans toward the 2nd mortgage is the possibility you will be laid off. If this happens, you will be taxed on the money you took from your 401K as income, and could possibly be subject to early withdrawal penalties.