Financial Planning for Generation X & Y Women
 
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Expert Q&A Archive

07/31/2006
Home Equity Loan vs. 401(k) Loan
"Of course it depends on what your principal amount is and what the interest rates are, but is there a rule of thumb whether it's smarter to, say, get a home equity loan as opposed to borrowing against your 401(k)? And I'm talking about, say, an amount of money that would be equal to 30% of your home value. So is there a rule of thumb as to which way is smarter or is it totally dependent on interest rates?"
Gary Silverman, CFP®:
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There is no "rule of thumb" but some observations will likely help your choices. With a home equity loan (HEL), you are paying interest to a bank. With a 401k, the interest is going back into your account. Win for the 401k. With a HEL, you can have a very long payoff period. The 401k needs to be paid off relatively quickly. Whether this is an issue depends on the reason for the loan. However, the 401k kinda forces you to get the loan paid off, which is usually a good idea, all things being equal.

With a HEL, you are losing the interest that you pay to the bank. With a 401k you have an "opportunity cost" which is what the account would have done had you not taken the money out. Which wins depends on whether the market goes up or down and how much compared to the interest rate cost. With a HEL, likely the interest is deductible. It is not with a 401k. This is a very minor win for the HEL.

Of course, the smartest thing is often not borrowing the money. Is this expense either 1) truly necessary, or 2) will earn a lot more money than it costs?
Barbara Babcock:
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Talk to your 401(k) plan administrator before you take any action, to see what rules you may have in place regarding withdrawals, and at what interest rate you will have to pay back your loan. Also, be aware that if you have a traditional (not a Roth) 401(k) you may have to pay income taxes and a 10% penalty on any withdrawal. While you can dip into your 401(k), you pay a big price to do so. As for home equity loans….before you borrow against your home, review your budget to make sure that you will be able to make your payments without any problem. Remember that any time you are unable to make a payment on a mortgage or equity loan, you put your home at risk of foreclosure.
Elizabeth Goldsmith:
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The following answers are based on a few indicators given in the questions, obviously, you are well advised to seek out individual advice based on a more in depth view of your financial situation and goals. But given that caveat, here goes: 1. A general rule of thumb is not to borrow against 401(ks)and one of the reasons is that people have a hard time putting the money back. Find out if there are penalties for withdrawal. The nature of 401(ks) is that they build best when they are untouched and there are tax considerations as well. Home equity loans may be a better choice, as you say, depending on interest rates. Comparison shop, usually credit unions offer the lowest interest rates on loans. Of course the more fundamental question is do you really need a loan? Do you need the money to invest in something which will increase in value or decrease? Is it for an emergency or crisis (roof leaking) or for a luxury item (pool)? If you decide you need the loan, get the best rate and pay it off quickly. The way to wealth and security in American is to own things free and clear, to invest in assets which will increase in value, to avoid debt as much as possible, and when you have debt to get rid of it as quickly as possible. Although time and money management are thought of as different constructs, in the financial world they are closely linked.
Delores Lenzy - Jones, CPA, CIA:
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It truly a matter of preference and how you want to manage your financial position. With a home equity loan you will acquire debt, however, you will be able deduct the interest expense associated with the loan. Borrowing against your 401K is essentially free money. You do not incur a tax you can deduct. However, you borrow principal and interest from yourself and pay back yourself. My personal preference is borrowing against my 401K.
Gail V. Marquet:
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It's never a good idea to borrow against your 401(k). Should you leave the company before the loan is repaid in full (either voluntarily or involuntarily), the outstanding balance is considered a withdrawal by the IRS and subject to 40% in taxes and penalties. In this instance, the home equity loan would be the better choice assuming your property is increasing in value and not in a depressed market.
Ellen Hoffman:
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Although interest rates are one of them, you should consider a number of factors in making this decision. Among the key pitfalls of borrowing the money from your 401k are that unlike with a home equity loan, the interest is not deductible...and if you leave your job, you will have to repay it immediately. For a good summary of pros and cons, check out this source: http://www.401khelpcenter.com/loans.html .
Alyssa Rakovich:
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Borrowing against your 401(k) is one of the most expensive ways to borrow money - remember whatever you borrow has to be paid back with after tax dollars - you are paying income tax on the amount of money you pay back into your 401(k) as well as the rate of interest the company charges - Also, if you retire or are seperated from employement the amount you borrow must be repaid or it becomes a distribution which is taxed as ordinary income and may result in penalties. A home equity line of credit is attached to your home so it is extemely important to make timely payments - the home equity depending on the amount can be tax deductible because you must pay interest only -sometimes it is difficult to pay off these equity lines becuase you are only required to make interest payments and it takes discipline to make additional payments to actually pay off the equity line - an equity line is usually based on prime - prime is at 8.25% most home equity lines of credit are based on prime +/- We have current home equity at prime minus .25 or 8% - There is no cost to set up a home equity line of credit but equity lines usually have terms - you usually have to keep the line open for a period of years usually 3-5 years - simply keep the line open - you don't have to have a debit balance for the line to stay open - but if you sell your house you may have to pay some sort of penalty for closing the credit line before the term has ended. Ask yourself What is the money going to be used for? How long will it take to pay it back - usually the 401(k) will give you a loan with a fixed rate and terms that it must be repaid within a period of time 5 years for example - Look at your cash flow, look at the rates and look at your income tax bracket to see which fits best.
Elizabeth Rusnak:
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I generally would not recommend drawing from a 401(k). That is retirement money, and you can generally make a better return leaving it invested. Borrowing from the equity in your home may be advantangeous because (depending on how you use the money), the interest you pay on the 2nd mortgage loan may be tax deductible.

So in the long run, by borrowing the money (rather than draw it from the 401(k) plan) you are reducing your tax exposure by:
1. not paying the tax that would result from the draw on your 401(k), and;
2. deducting the interest expense on your tax return (consult a tax advisor to insure you can do this).
Jeff Kyle:
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What are you wanting to utilize the money for? It may not be smarter to do either.
Lourdes Sampera-Tsukada:
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Currently, I would advise anyone to not take their 401k program and look at a 2nd loan FIXED and not the Equity Lines of Credit. The rate fluctuates on Equity Lines and the rates are still good on the fixed seconds. The disadvantage as well is that most Equity Lines of Credit are for a 10 year term (interest only payments which fluctuate in rate and the principle balance on the loan is NEVER touched and is due at the end of the 10th year). The advantage of the 2nds is: you can do a 30/15 which means: a payment of a 30 year term but the note/loan is due in full by the 15th year = lower monthly payments and lets you set aside money to either double up your payments when you can OR refinance to get rid of the 2nd loan utilizing the equity of your home.
 

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