Is it better to borrow from my 401(k) or use my home equity?
Home equity vs. 401(k): Understanding the pros and cons of tapping into home equity versus 401(k) when you need cash.
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.
Many American employees participate in 401(k) retirement savings accounts in order to prepare for retirement and save money on taxes. When in need of cash, whether for an emergency, home improvement, college tuition or to consolidate debt, it can be tempting to take a loan out against your 401(k) to meet your needs.
Alternatively, homeowners have the option of accessing cash in the form of a home equity loan, home equity line of credit (HELOC), or cash-out refinance mortgage. Home equity lending allows you to either replace your existing mortgage (a cash-out refi) or take a second mortgage (traditional home equity loan or HELOC). These loans are secured by your home, and therefore offer low interest rates and favorable repayment options, without risking your retirement.
In general, it is usually a better option to use a HELOC or home equity loan over a 401(k) loan, however, every situation requires a unique solution. HELOCs tend to be more flexible in terms of borrowing and repayment.
Home equity loans, home equity lines of credit (HELOCs), and 401(k) loans are all financial options for accessing cash without the risk of using a credit card or personal loan.
401(k) loans allow you to borrow against your retirement savings but come with penalties, fees, short repayment periods (5 years), and additional terms set forth by the employer.
Home equity lines of credit (HELOCs) allow you to borrow against the equity you have accrued in your house with more flexibility in borrowing limit and repayment than with a 401(k), however, it can include closing costs and other fees.
Borrowers should compare the costs of borrowing (fees, penalties, and charges), the interest rates, and repayment terms to determine which type of loan is best for their needs.
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 There is a 10% penalty on the loan amount, and you’ll have to pay federal income tax on the amount withdrawn if you choose to withdraw money before that age.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, 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.
How a 401(k) loan works
A 401(k) loan is a loan type specifically for retirement saving accounts, which allows you to borrow money from your own 401(k) account rather than a bank or other outside lender, making it an attractive option for those who want to avoid debt. Your employer sets the rules and terms of the 401(k) as well as 401(k) loans, so if they offer one, you can seek clarification directly from them.
Loans from your 401(k) are easy and convenient because you don't need to go through extensive paperwork or credit checks. However, there are often fees and taxes on them when considered taxable income as well as interest. If it is not paid back in full and on time (not to exceed five years) or else risk triggering an Early Withdrawal Penalty tax if taken before 59 ½ years old. So, it's best to carefully consider all available options while weighing risks.
Depending on the details of your plan, you may be able to borrow up to 50% of your vested balance or $50,000 (whichever is less). If the balance in your plan is under $10,000, you may even be able to borrow up to 100% of it. The repayment of loan proceeds typically involves lump-sum payments through payroll deductions spread out over five years.
Advantages and disadvantages of borrowing from your 401(k)
Borrowing from your 401(k) can sound like a great idea when you need funds quickly, as it doesn’t require credit score approval, and any interest is paid back into your account rather than to a lending institution. However, this option should be handled with caution.
Firstly, you will be subject to double taxation if you do borrow from your 401(k). As the income initially deposited was pre-tax, if you borrow from it for other purposes, you will use potentially taxed income to pay it back. Then when you reach retirement age, the money withdrawn is also taxed. Secondly, should you decide to take out a loan from your 401(k), if for any reason you leave your current job within five years of borrowing, the remaining amount must be repaid or charges may be applied. This means limited job mobility when taking out a loan through a 401(k).
Generally speaking in these situations more research is needed about other options available before taking on debt from your own retirement savings account. It’s important to weigh up the advantages and disadvantages carefully because of the long-term implications associated with borrowing from a 401(k). Speaking with a financial advisor can help you determine the exact risks involved in tapping into your 401(k) early based on your circumstances. Getting cash out with a mortgage refinance
Using a home equity line of credit
A Home Equity Line of Credit, or HELOC, is a type of second mortgage 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.* 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.
How a HELOC works
A home equity line of credit (HELOC) provides a way to access the equity built up in your home as a loan. It is secured against the value of your property, with a total amount that can be borrowed based on the available equity in your property (usually 80%-90% of its appraised value). When making any considerations towards applying for a HELOC it is important to take into account that the borrower will not be able to borrow all available equity without exceeding 80%-90% of the current home’s appraise value when combined with primary home loans.
HELOCs function similarly in terms of allowing you to borrow and make payments against your principal balance, paying interest charges only on amounts outstanding after paying down the balance. It is typically divided into two distinct periods, the draw period and the repayment period. During the draw period (often 5-10 years) you can withdraw funds from your HELOC and make payments toward interest and balance. During the repayment period (usually 10-20 years), you are no longer able to withdraw funds and must repay the balance and interest.
Advantages and disadvantages of a Home Equity Line versus a 401(k) loan
One significant benefit of HELOCs is that they typically offer much lower interest rates than credit cards and other forms of debt. This can make it easier to pay off the loan in full when compared with higher-interest debt products. Additionally, if the funds obtained from your home equity loan are used for purposes that enhance the value or equity of your home—such as installing a new kitchen or building a deck—you may qualify for additional tax deductions on the loan interest. Home equity loans generally have longer repayment periods with terms of up to 10 years or more, making it more feasible to pay off larger debt amounts without feeling too much strain on your personal finances.
It’s important to remember that while there are many advantages associated with home equity loans, there are also potential drawbacks and financial risks involved. Most notably, if you default on your loan payments, there is a risk that you could lose your home altogether since part of your property’s value serves as collateral against the loan amount.
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.