401(k) Loan vs. HELOC | Which Loan Is Better In 2023?

Is it better to get a HELOC or 401(k) loan?

A HELOC is almost always better than a 401(k) loan. Both options let you borrow money “from yourself,” but they’re very different in practice.

A home equity line of credit (HELOC) borrows from your property value. By contrast, the money in your 401(k) is actively working for you by accruing interest over time. Cashing those funds out means a serious setback in your retirement savings.

As long as you can qualify for a HELOC, that’s likely to be your best option.

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401(k) loan vs HELOC comparison

Here are some of the main features of a 401(k) loan vs. a HELOC. We’ll dig deeper into the pros and cons of both loan types below.

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A HELOC is almost always better than a 401(k) loan

Let’s sum up why a home equity line of credit almost always wins in the 401(k) loan vs. HELOC fight.

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• You are not risking your future comfort and security during retirement
• You can take longer to repay your loan than with a 401(k) loan, making each monthly payment smaller
• The loan is flexible; you can borrow, repay, and reborrow at will during the HELOC draw period
• You pay interest only on your outstanding balance; if you borrow nothing, you pay nothing
• You may be able to fix your mortgage rate on some or all of your HELOC borrowing
• Should be offered a lower interest rate compared with most other types of loans

Of course, there are some drawbacks. Most importantly, you must be a homeowner; you must have built up enough home equity to qualify for a HELOC; and you need a good credit score, usually 680-700 or higher.

What is a 401(k) loan?

A 401(k) loan is a type of loan that allows you to borrow money from your 401(k) retirement savings account. A 401(k) is a retirement plan typically offered by employers in the United States.

Each employer gets to set its program’s rules. Your employer and account provider may or may not allow loans and early withdrawals; for those that do, rules and loan terms can vary.

How do 401(k) loans work?

Assuming you’re allowed to borrow from your 401(k) and have sufficient funds saved, you can borrow up to 50% of your plan’s vested balance or $50,000, whichever is less. If your plan’s balance is less than $10,000, you may be able to borrow a larger proportion.

Borrowers must repay the loan, including interest, usually within five years. Repayments are made through payroll deductions. The interest charged on the loan is often lower compared to other loans, and it goes back into the borrower’s 401(k) account. If the loan is not repaid as agreed, it may be considered a distribution, subjecting the borrower to taxes and potential penalties.

Whatever your employer’s rules say, you must repay your debt in full within five years — unless you’re using the loan to buy a home, which must be your principal residence. And you must make at least one payment each quarter. If you fail to meet either of those requirements, the IRS will likely declare your loan a withdrawal and you’ll get a large tax bill and have to pay early withdrawal penalties.

Pros and Cons of 401(k) loans

Pros

401(k) loans really have only three advantages compared to HELOCs.

1. They tend to have ultra-low interest rates
2. They don’t require credit checks or other barriers to approval
3. They don’t require you to be a homeowner or have equity

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Cons

For most borrowers, though, the downsides of a 401(k) loan far outweigh the advantages. The major drawbacks of borrowing from your retirement account include:

• You typically can’t make any contributions to your 401(k) while you have an outstanding loan
• Your employer will also stop making contributions to your 401(k) while the loan is active
• You could end up with a substantial loss to your retirement income
• You may not be able to borrow as much as you could with a HELOC
• You could have higher monthly payments than with a HELOC due to the shorter repayment period
• You must receive a single lump sum. That’s less flexible than a HELOC’s line of credit
• You will pay interest on the full loan amount, not just on your balance

You might be considering a 401(k) loan if you can’t get a HELOC, whether because your equity levels are too low or because you don’t qualify. But there are other options to explore that won’t impact your retirement.

When does it make sense to borrow from your 401(k)?

There’s really only one situation in which borrowing from your 401(k) makes sense. And that’s when you have a serious need for cash and no other way to access it affordably. Perhaps your credit score is too low or you already have too many existing debts to get a different type of loan.

If you absolutely need to borrow from your 401(k), be sure not to borrow more than what’s required. And try to pay it back as quickly as you can so you can resume making deposits and benefitting from your employers’ matching program (if available).

Before tapping a 401(k), it’s a good idea to reach out to a trusted financial advisor who can look at your portfolio and help evaluate your options. It could be there’s a better type of loan you haven’t explored yet. Take the time to evaluate all your options and find the best solution for your current needs.

Alternatives to 401(k) loans

Navigating personal finance and financial planning can be challenging, especially when unforeseen expenses loom. A 401(k) loan may seem like an accessible solution, but there are alternatives that can leave your retirement funds intact.

Tapping into your IRA

If your retirement plan includes an Individual Retirement Account (IRA), you could consider this as an alternative. Some IRAs allow you to withdraw without penalty for specific purposes like a first-time home purchase or medical expenses, offering a level of flexibility in contrast to a 401(k).

Consider early withdrawals

Another alternative is an early withdrawal, but this option may come with financial drawbacks. If you withdraw funds before retirement age (59 ½), you might face income taxes on any gains, along with a potential 10% penalty. The exact penalties can depend on the nature of the hardship prompting the early withdrawal.

Despite the absence of repayment obligations, early withdrawals may significantly impact your retirement plan. The prime reason being they can diminish your retirement funds, affecting your future financial stability. Remember, these withdrawals are not tax deductible, which may further strain your finances.

Hardship distributions

A specific type of early withdrawal, known as a hardship distribution, could be a potential option. The IRS defines a hardship distribution as funds withdrawn in response to an “immediate and heavy financial need.” This category covers specific circumstances, such as:

• Select medical expenses
• Costs associated with buying a principal home
• Tuition, fees, and education costs
• Preventing eviction or foreclosure
• Funeral and burial expenses
• Emergency home repairs for uninsured casualty losses

In these instances, you are not required to pay back the withdrawn amount. However, the term “hardship” can be subjective, and not all personal financial difficulties will qualify you for this type of withdrawal.

What is a HELOC?

A Home Equity Line of Credit (HELOC) is a type of loan that allows homeowners to access the equity in their homes. It can be used for various purposes, including debt consolidation and home improvement projects.

A HELOC provides a revolving line of credit, similar to a credit card, where borrowers can borrow and repay funds within a specified draw period. Interest is only charged on the amount borrowed, not the entire credit line. Repayment terms vary but often include a repayment period after the draw period ends.

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How do HELOCs work?

A HELOC is typically considered a second mortgage, as it is secured by the borrower’s home. The amount that can be borrowed depends on the available equity in the property. The interest rates on a HELOC may fluctuate over time, as they are often variable and tied to the prime rate and other market conditions.

Just note that you won’t be able to borrow all your available equity. Most lenders set a maximum HELOC limit between 80% and 90% of the home’s appraised value. That means your HELOC amount and your primary home loan, when combined, can’t exceed 80%-90% of the property value.

It’s important to note that, like any loan, a HELOC carries risks. Failing to make timely payments can result in foreclosure and the loss of the home. Additionally, using a HELOC for debt consolidation may only be beneficial if the borrower maintains disciplined financial habits to avoid falling back into debt.

HELOC rates and payments

HELOCs are almost all variable-rate loans, meaning their rates go up and down in line with other interest rates. However, you may be able to fix the rate on some or all of your balance.

HELOCs have two phases. During the initial draw phase, you can borrow, repay and borrow again as often as you want, making them exceptionally flexible. And you pay the interest only on your loan balance each month.

Eventually, the repayment phase kicks in. Then you can’t borrow anymore and have to zero your loan balance over a set period. However, lenders offer a wide array of options when it comes to the length of each phase. So you can choose to give yourself plenty of time to comfortably repay your loan. There’s no five-year limit, as there is for 401(k) loans.

Alternatives to HELOCs

If you’re worried about the complexities of a variable-rate, multiphase loan, you might consider any of these HELOC alternatives.

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• Cash-out refinance: Cash-out refinancing involves replacing your existing mortgage with a new one that has a higher loan amount. The difference between the new loan and your old mortgage is received as a lump sum cash payout. This option allows you to tap into your home equity while potentially securing a lower interest rate and extending the repayment period. However, it involves closing costs and may reset the terms of your mortgage.
• Home equity loan: A home equity loan, also known as a second mortgage, provides a lump sum of money based on the equity in your home. Unlike a HELOC, a home equity loan offers a fixed interest rate and predictable monthly payments over a specified loan term. This option can be suitable for one-time expenses or large projects, as it provides a lump sum upfront. However, keep in mind that you’ll be paying interest on the entire loan amount from the start.
• Personal loans: Personal loans are unsecured loans that can be used for various purposes, including debt consolidation or home improvements. They are typically based on your creditworthiness and income rather than your home equity. Personal loans offer fixed rates and predictable monthly payments over a specified term. While they may have higher interest rates compared to home equity options, they don’t put your home at risk.
• Credit cards: Credit cards can be used for smaller expenses, but they generally have higher interest rates compared to other loan options. If you’re considering using credit cards for debt consolidation or home improvements, ensure you have a solid plan to pay off the balance quickly to avoid accumulating excessive interest charges.

Think carefully before you borrow using any product. Do you absolutely need the funds? And are you choosing the least costly option available to you?

FAQ: 401(k) loan vs HELOC

Your next steps

For HELOCs and home equity loans, the only way you can be sure you’re choosing the least costly option is to get quotes from multiple lenders. Then compare the annual percentage rates (APRs) you’re offered. APRs reflect the loan costs as well as the raw interest rate.

A mortgage lender can help you evaluate your options and compare costs to find the best loan type for you. Ready to get started?

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