HELOC vs. 401(k) loan: which is the better option?
Saving for retirement is essential for creating a financially secure future; however, there may be times along the road to retirement when a large amount of cash is needed for emergencies, to start a small business, pay for home renovations, or other expenses.
If you're a homeowner, you may consider getting a home equity line of credit (HELOC) vs. borrowing from your 401(k) employer-sponsored retirement savings plan. Taking a loan from your 401(k) before the IRS-specified age of 59 1/2, will result in penalty fees.
Read on to learn more about a 401(k) loan vs. a HELOC.
At Credit Union of Southern California (CU SoCal), we make getting a Home Equity Line of Credit (HELOC) easy.
Call 866.287.6225 today to schedule a no-obligation consultation and learn about our home equity lines of credit, auto loans, personal loans, checking and savings accounts, and other banking products. As a full-service financial institution, we look forward to helping you with all your banking needs.
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What is home equity?
Home equity is the amount of your home that you own that is not encumbered by a first or second mortgage loan. For example, if you do not have a mortgage, then you have 100% equity. If you have a mortgage, the lender "owns" part of your home. As you pay off your mortgage your equity (ownership) increases.
What are HELOCs and how do they work?
A
Home Equity Line of Credit (HELOC) is a type of “revolving” credit, similar to a credit card. HELOCs come with a credit limit based on the amount the borrower is approved for. During the "draw period,” a variable interest rate is charged on the amount of the loan that's used. The draw period is followed by a repayment period when the loan converts to a fixed interest rate.
There are
HELOC pros and cons to consider. One of the advantages of a HELOC is that you can take out money as you need it, and you will only pay interest on the amount you use. However, because a HELOC is a type of
second mortgage and is secured by your home, if you do not repay the loan, the bank can foreclose.
What is a 401(k) loan?
Most people who have worked for an employer have a 401(k)-retirement savings account. As you may know, the money that you put into a 401(k) goes directly into your account before federal, state, and other taxes are taken out. As such, the account grows tax deferred until the money is withdrawn in retirement. Because these accounts are designed for retirement savings, if money is withdrawn as a loan to yourself, any taxable distribution before age 59½ is subject to a mandatory withholding of 20%. For this reason, a 401(k) loan vs. a HELOC is a serious matter, as taking a 401(k) loan could cost you quite a lot.
According to the Internal Revenue Service (IRS), your 401(k) plan may allow you to borrow from your account balance. However, you should consider a few things before taking a loan from your 401(k).
If you don’t repay the loan, including interest, according to the loan’s terms, any unpaid amounts become a plan distribution to you. Your plan may even require you to repay the loan in full if you leave your job. Generally, you must include any previously untaxed amount of the distribution in your gross income in the year in which the distribution occurs. You may also have to pay an additional 10% tax on the amount of the taxable distribution, unless you:
1) Are at least age 59 ½, or
2) Qualify for another exception, such as hardship distribution.
How to HELOCs and 401(k) loans compare?
When considering getting a HELOC vs. borrowing from your 401(k), there are important financial factors to consider. Looking at these in detail can help you decide between a HELOC or 401(k) loan.
Interest rates
HELOCs: Variable interest rate during the draw period, which adjusts to a fixed rate during the repayment period.
401(k) loans: Interest rates on 401k loans are typically lower than other products; additionally, the interest paid will go back to the borrower’s account.
Credit score requirements
HELOCs: Some lenders will accept a credit score as low as 620; however, you may be charged a higher interest rate than if you have a credit score in the 700s.
401(k) loans: No credit score requirements.
Funding.
HELOCs: HELOCs are funded by a mortgage lender who gives the borrower a line of credit based on the borrower's home equity.
401(k) loans: If you work for an employer and are not self-employed, a 401(k) can be funded from your paycheck using pre-tax dollars. Meaning, that money is rolled into your 401(k) account and will not appear in your paycheck.
Loan limits.
HELOCs: The loan limit you can be approved for is based on the lender's loan limit policy and the amount of your home equity, as determined by the lender based on your home's appraised value and the mortgage amount you owe.
401(k) loans: A loan from your employer’s 401(k) plan is
not taxable if it meets the following criteria. Generally, if permitted by your plan, you may borrow up to
50% of your vested account balance up to a maximum of $50,000.
Eligibility requirements.
HELOCs:
A good repayment history on your current mortgage and other loans or credit, a minimum credit score of 620, sufficient income to repay the loan, and 15-20% home equity are some of the HELOC eligibility requirements.
401(k) loans: Some 401(k) plans permit participants to borrow from the plan. The plan document must specify if loans are permitted.
Repayments.
HELOCs:
HELOC repayments are generally made in two phases. All HELOCS have a “draw period” (typically 10-15 years) and a “repayment period” (typically up to 20 years). During the draw period, you can borrow as much of the funds as you need, and repayments are made based on interest-only. After the draw period ends, the HELOC repayment period begins. At this time, most HELOC interest rates will adjust to a fixed rate and monthly payments will include both principal and interest on the outstanding balance.
401(k) loans: The loan must be repaid
within five years unless the loan is used to buy your main home. The loan repayments must be made in
substantially level payments, at least quarterly, over the life of the loan.
You must reduce the $50,000 amount, above, if you already had an outstanding loan from the plan (or any other plan of your employer or related employer) during the
one-year period ending the day before the loan. The amount of the reduction is your highest outstanding loan balance during that period minus the outstanding balance on the date of the new loan.
Taxes.
HELOCs: HELOC interest is
tax deductible only if the borrowed funds are used to buy, build, or substantially improve the taxpayer’s home that secures the loan.
401(k) loans: Certain participant loans may be treated as taxable distributions. If a distribution is made to you under the plan before you reach age 59½, you may have to pay a 10% additional tax on the distribution.
It is recommended that you speak with your plan administrator and a tax professional before taking a loan from your 401(k).
Collateral.
HELOCs: A HELOC uses your home as collateral.
401(k) loans: No collateral is required.
Upfront costs.
HELOCs: Getting approved for a HELOC requires an application that is submitted to a lender. Some lenders charge loan application and processing fees, and closing costs if the loan is approved.
401(k) loans: There are usually no upfront costs to obtaining a 401k loan; however, borrowers may be required to pay loan origination or administration fees.
Impact on savings.
HELOCs: No impact on savings.
401(k) loans: This type of loan is essentially a loan to yourself from your retirement savings account.
Taking money out also requires that you repay yourself. Depleting your 401(k) may result in lost savings and interest you would have earned on the money.
When does it make sense to get a HELOC?
If you have ample home equity, steady income with which to repay the loan, and intend to stay in your home, then getting a HELOC vs. borrowing from your 401(k) is a good choice, because getting a HELOC preserves your 410(k) for retirement.
When is it better to get a 401(k) loan?
A 401(k) loan can be a better option if you intend to sell your home soon or you do not want to take on the risk of getting a loan that uses your home as collateral. A 401(k) loan may be easier and quicker to get than a HELOC which requires an application process, home appraisal, and closing.
Alternatives to HELOCs and 401(k) loans
Home equity loan. Like a HELOC, a home equity loan is based on the equity in your home. These loans have a fixed interest rate for the duration of the loan term. Interest is charged on the entire loan amount, whether you use the money or not.
Cash-out refinance. Getting cash-out during the refinance of your mortgage means borrowing more than what you owe on your current mortgage and getting a cash disbursement of the extra funds at closing. You can use the cash any way you choose. Refinancing your current mortgage to a new mortgage could help you lower your monthly payments, if you can get a lower interest rate than you currently have.
Personal loan. Credit unions and banks offer a wide variety of secured and unsecured personal loans to meet a wide variety of borrowing needs. Variable and fixed rate personal loan options are available.
IRA. Individual Retirement Arrangements (IRAs) allow you to make tax-deferred investments to provide financial security when you retire. Most IRAs have penalties (imposed by the Internal Revenue Service) for withdrawing money from an IRA if they money is taken out before you reach the age requirement. To avoid tax penalties, be sure to check with a tax professional or do research on the rules associated with your IRA before you make a withdrawal from the account.
Credit cards. Some credit card companies offer a promotional 0% APR (annual percentage rate) for 12 months, on new accounts and balance transfers. After the promotional interest rate expires, there will be a new higher rate applied to the outstanding balance. This option can be good if you need extra purchasing power in the short term.
Why Savvy Consumers Choose CU SoCal
For over 60 years, CU SoCal has been providing financial services, including HELOCs, car loans, personal loans, mortgages, credit cards, and other banking products, to those who live, work, worship, or attend school in Orange County, Los Angeles County, Riverside County, and San Bernardino County.
Please give us a call today at 866.287.6225 today to schedule a no-obligation consultation with one of our HELOC experts.
Get Started on Your Home Equity Line of Credit Today!