Faced with the challenge of evaluating ways to access cash? Many people are considering their financial options, but it’s important to understand considerations for each.
Using a home equity line of credit
A HELOC is a type of loan that uses your home as collateral in exchange for a line of credit for an amount that the lender determines. Similar to a credit card, but often at a fraction of the interest rate, you can draw on it as you need to. Since HELOCs are secured by your house, lenders are willing to offer lower rates than you would find with an unsecured loan. Your equity determines the amount you can expect to receive.
Some lenders offer variations on the standard HELOC. For example, Figure’s HELOC provides the entire loan amount upfront at a low fixed rate. You can continue drawing on the credit line as you repay what you borrow, but the rate may change at that time.1 HELOCs are a great option for responsible borrowers financing essentials or paying off higher-cost debt and are a great option for personal financing, but it’s important to remember you’re using your home as collateral so the lender can repossess it if you cannot make the payments.
In general, HELOC rates are lower than many other types of consumer debt and the interest is tax-deductible in the case you choose to use it for home improvement, which makes it a great option for homeowners.* In addition, Figure can offer access to your equity in as little as 5 days and the application is all online and can be done in 5 minutes.3
HELOCs typically have longer repayment terms than personal loans, which can make the monthly payments more affordable because payments are spread out over an extended period. While stretching out repayment over several years can keep your monthly payments low, it results in paying more in interest. You're putting your home at risk, and if you run into financial troubles and cannot make your loan payments, the lender could foreclose on your property.
Using a HELOC for debt consolidation may help you reduce your interest rate and pay off your debt faster.
Borrowing from your 401(k)
Because that money is meant for retirement, withdrawals are discouraged before you reach age 59 ½. There is a 10% penalty on the loan amount and you’ll have to pay federal income tax on the amount withdrawn, if you choose to withdraw money before that age.
Exceptions to this include: you’re using the money to pay medical expenses, you’ve become disabled, if you’re required to perform military duty; and/or you’re required to follow a court order. The other exception is if you're 55 and an employee who is laid off, fired, or who quits a job between the ages of 55 and 59 ½, you may access the money in your 401(k) plan without penalty, according to the IRS.
Some 401(k) plans allow participants to borrow from their retirement savings. If you've built up some money in a retirement account, that may be a source of funds for consolidating your debt. It can be easier to borrow from your 401(k) than getting approved for a loan from an outside lender. Plans often require employees to repay through payroll deductions so your monthly take-home pay will be reduced by the loan payment.
401(k) plans typically require that loans be repaid within five years meaning your monthly payments will be higher than loans with a longer term. Some plans do not allow participants to contribute to the plan while they have a loan outstanding. You'll also miss out on any matching contributions from your employer during that time.
Let’s look at an example. Brenda is in debt with $35,000 in credit cards and personal loans. She makes a salary of $150,000 a year and holds about $25,000 in a 401(k) account. She considers using her 401(k) but learns that approximately $14,000 will go to penalties and taxes, which would be like paying 40% interest to pay off your debt.
Withdrawing from your 401(k) is typically a poor choice because you’ll lose the opportunity to earn compound returns on that money. You could also be subject to penalties and a higher-income tax bill.
Getting cash out with a mortgage refinance
According to Bankrate.com, cash-out mortgage refinance rates are around 3.7% APR in 2020. So if you need to lower your rate, it might make sense for you to do a cash-out refinance. While this is an option for many borrowers, lending criteria are becoming more strict.
“All lenders are looking more closely to see if someone is already in forbearance and whether borrowers have jobs,” says CD Davies, head of lending at Figure. In the past, he says, verification of employment happened shortly after application. Now borrowers can expect verification of employment within 48 hours of closing.
Evaluating whether to do a cash-out refinance will depend on a few things:
- How does the interest rate on your current mortgage compare to the interest rate you’d qualify for on a new mortgage?
- Are you comfortable paying several thousand dollars in closing costs to refinance your mortgage?
- Have you considered this will increase your balance and it will take you longer to pay off your mortgage unless you refinance into a shorter term?
- What are the closing costs, monthly payments, and total interest costs over the life of the loan?
- Are you paying mortgage insurance premiums? Would a cash-out mortgage refinance allow you to get rid of them?
If you need a lower mortgage rate and to consolidate debt, this may be the right option for you. Compare this against a HELOC to see which is the better route for you.
Ultimately, there are many benefits of using your home equity versus cashing out of your 401k.
The cost of borrowing from your 401(k) is the amount you would have earned if you’d kept the money in the 401K, also known as an "opportunity cost". Because your 401(k) accumulates tax-free, the return on the fund is an approximation of the after-tax cost. If your 401(k) has been earning more than the after-tax cost of the home equity line, the opportunity cost of borrowing from your 401K is higher than the cost of the home equity line.
If you plan to use a HELOC or Cash-Out Mortgage Refinance, you avoid having the funds taxed as income and early withdrawal penalties associated with a 401(k) loan. You’ll also likely benefit from locking in a lower rate than with credit cards or personal loans.