401(k) Loan vs HELOC to Cover Life's Unexpected Expenses
If you own a home and have a 401k through work, you may have at least two ways to raise quick cash for:
A new roof, HVAC system, or other major home repair
Car repair or replacement
A child’s college tuition
Nearly any of life’s large expenses
While an emergency fund is typically the best source, many people do not yet have one and need to borrow funds for unavoidable expenses.
Assuming you need to borrow, should you get a 401k loan or home equity line of credit (HELOC)?
401(k) Loan For Major Expenses
Unlike a 401(k) withdrawal, a 401(k) loan does not require hardship for eligibility.
You can take the loan simply because you need the cash.
Borrowing limits are $50,000 or 50% of your account balance, whichever is less. Those with accounts up to $10,000 may borrow the whole balance.
You have up to five years to pay back the loan with interest. The key difference between a 401(k) loan and other loan types is that interest goes to you, not the lender.
For example, you borrow $20,000 at 8% interest on a five-year term. The roughly $4,300 interest paid ends up in your account. This is to make up for lost gains. In this way, you don’t do too much damage to your retirement savings.
But a 401(k) loan isn’t foolproof. You incur penalties and tax consequences if it isn’t repaid in full. And the 401(k) plan can even call the loan due if you leave your job. Check your employer’s plan details before taking a loan.
401(k) Loan Pros vs. a HELOC
You pay yourself back with interest
Receive funds faster
Your home is not collateral for the loan
You don’t need equity in your home
The process can be completed online
Does not impact your credit score
May not count against your debt-to-income for other borrowing
401(k) Loan Cons vs. a HELOC
Stiff tax penalties for non-payment
The loan can be called due if you leave your job
Not all employers offer them
You can borrow a max of $50,000 over 12 months, even if you pay back the loan
How to Apply for a 401(k) Loan
Speak to your company’s human resources department. It may be able to give you program details and how to apply.
The 401(k) loan program is likely run by your company’s retirement plan administrator, often a third party.
That company may have a website where you can apply, check loan status, and request funds.
Opening a HELOC to Cover Expenses
Homeowners with equity in their homes may be able to turn that equity into cash with a HELOC.
Many lenders allow a HELOC up to 90% of the home’s value. For example, you owe $250,000 on a $400,000 house. You may be eligible for $110,000. (Home value X 0.9 - existing loan balance).
Some lenders allow you to borrow 80%, 85%, or even 100% of your home’s value, so shop around.
HELOCs come with a 10-year draw period in which you can borrow and pay back as needed. You make an interest-only payment during this time. Then it enters a 10- to 20-year repayment period with regular payments.
Interest rates are based on the prime rate, for example, “prime plus one” or “prime minus one-half.” As of this writing, prime is 8.5%, so a HELOC rate at “prime plus one” would be 9.5%.
You typically need a high credit score. Your lender will verify your income and assets. In this way, a HELOC is harder to qualify for than a 401(k) loan. Those with marginal credit or low home equity may not be approved.
HELOC Pros vs. a 401(k) Loan
Borrow and pay back as needed
Higher potential loan limits than 401(k) loans
No risk of the loan coming due if you change jobs
Interest may be tax deductible if used for home improvements
Not dependent on whether your employer offers a plan
HELOC Cons vs. a 401(k) Loan
Interest goes to the lender, not you
You need substantial equity in the home
Tougher qualification standards
Payments will count against your debt-to-income for other borrowing
Rates are variable and can rise during the loan term
Closing costs could be higher
How to Apply for a HELOC
Speak to local credit unions, national banks, and mortgage companies. Look for a lender that offers low or no closing costs.
Apply by submitting pay stubs, W-2s, and bank statements. The lender may require an appraisal, but some can determine your home’s value using online valuation tools at no cost to you.
The lender will take two to three weeks to process your application. If approved, you will sign final paperwork. Draw funds as needed using checks, a debit card, or online transfers, depending on your lender.
Contact a lender to see if you qualify.
Which One is Better?
If you have enough in your 401(k) to borrow against, this route might be better for you.
Arguments against this strategy state that you derail your retirement growth. But since you pay yourself back with interest, you make up for some – perhaps all – lost growth of your holdings.
However, you may not have enough in your 401(k). For instance, a $30,000 401(k) will yield just a $15,000 loan. If you have a $25,000 home repair, a HELOC may work better.
Home values continue to rise and homeowners are sitting on $299,000 in home equity on average, says ICE Mortgage Technology.
You may have enough equity for a substantial HELOC even if you’ve owned your home for only a few years.
In short, your best solution for large expenses depends on how much you need, your 401(k) balance, and available home equity.
Always check with a licensed tax advisor and financial planner before taking a 401(k) loan or HELOC.
Check Your HELOC Eligibility
If a HELOC is your better option, start by speaking to a lender. See how much you qualify for and if this loan suits your needs.
