Think before you tap 401(k) to pay off mortgage

Story originally appeared on USA Today.

Q: My husband and I have a terrible situation. Our mortgage rate is 9% with a loan balance of $122,000 and 25 years left to pay. Because of the market downturn, the home value is approximately $85,000. My husband is 57 and I am 55. When he turns 59½, would it be good to use our 401(k) retirement savings to pay off this mortgage? Or do we have other options?

A: No question, it's a bad situation.You did not indicate if the loan is a financial hardship, or if you and your husband are having trouble keeping up with mortgage payments.

If, indeed, you are severely stressed, then you should find out who owns the loan (FHA, Fannie Mae or Freddie Mac). You may be able to modify the loan under the HARP or HAMP programs. If none of these lenders owns the mortgage, you may still be able to negotiate a reduction through the Principal Reduction Alternative program. But you will need to demonstrate financial need.

If you can make the payments, the interest rate on the mortgage is really sickening, given today's rates. One way to recast this is to think of this loan as a credit card, at low interest (for credit cards). How would you approach paying off a large, expensive credit card debt? Here are some possibilities:

1. Accelerate principal payments. The goal here is not necessarily to pay off the entire loan, but to pay off, as quickly as possible, enough to have equity in the home (about $45,000 in additional principal reduction). That should make refinancing possible. Also, during this period the value of the home may increase so that there will be less difference between mortgage owed and then-current value.

2. Ask a Realtor or two to come over and do a market analysis. Is there anything you could do to improve the home relative to similar homes? Sometimes a thorough repaint, junk cleanup, or other fairly inexpensive alterations can make a big difference in appraised value. It's worth getting expert evaluation from a Realtor.

3. Ask the Realtor for recommendations on a mortgage broker and contact them. Some mortgage brokers are more creative than others, so it's worthwhile talking to several. It's particularly worthwhile to explore community lenders who may hold their own loans, or mortgage brokers who work with private investors. However, be very cautious with the terms of such loans, and have an attorney review the proposed loan.

4. Is there anyone in your circle of friends and colleagues who might be interested in making a private loan? Even if you pay a higher-than-current mortgage interest rate (say, 6%) it might be an attractive return for the investor. And even if you cannot borrow the full amount of the mortgage, you might be able to borrow enough to pay down the principal and refinance the balance. But the private loan should be reported as part of total indebtedness (otherwise it's fraud).

5. You might explore refinancing policies with your lender. Generally, a lender might be more willing to discuss loan modification if the loan is in default, but no one should attempt a so-called strategic default without consulting a reputable and knowledgeable real estate attorney.

6. You might explore the lender's policies on turning the property over to it. The lender may not be too enthusiastic, but if you are willing to move, you may want to talk this over with an attorney, as well.

Now to examine the original idea: Should you withdraw from your 401(k) to pay off the loan?

Based strictly on numbers, it is only worth paying off a mortgage if the interest rate on the mortgage exceeds what you might expect to earn from a diversified portfolio of investments. Historically, a portfolio of 60% stocks/40% bonds has earned approximately 8.6% (1926-2011), so you are right on the borderline of whether it would be worthwhile with a 9% interest rate. However, the psychological peace may more than outweigh simple numbers.

Before withdrawing the money, you should consider whether the remaining 401(k) will offer withdrawals sufficient to allow you to maintain your needed retirement income. Even though there will no longer be a mortgage payment, there will still be property taxes, home maintenance, insurance and incidental costs of homeownership. It's very important that retirees not become house-rich and cash-poor. You cannot replace the 401(k) funds with a home equity loan, and such a loan may be harder to secure once you are retired.

This is a situation where there are no good answers, but also tremendous flux in public policy. You should explore the suggested alternatives and keep a close eye on the news for any changes or new offerings in the next several years. As with most financial situations, the more money you can set aside for debt repayment and an investment war chest, the more alternatives you are likely to have in the future.