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Rebecca Safier is a personal finance writer and certified student loan counselor who specializes in student loans,…
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Not everyone has the cash laying around to pay for life’s expenses and emergencies.
Home improvement projects, unexpected home repairs, job loss, high-interest debt, education expenses, or home down payments are just a few expensive examples of what life can throw at you.
Two potential solutions to help fund the unexpected are home equity loans or 401(k) loans. One or neither might work for you, according to experts, but there are pros and cons to both.
A home equity loan, borrowing against the value of your home, can be an appealing option since these funds tend to come with lower interest rates compared to other borrowing options. However, interest rates have been going up in 2022 and are expected to continue rising.
Taking out a 401(k) could mean less interest paid, but borrowing when the stock market is down, like it is right now, only heightens your losses. “Portfolios are down because the markets are down,” says Mahesh Odhrani, CFP and president and founder of Las Vegas financial planners firm Strategic Wealth Design. “If someone were to borrow today, what they’re doing is essentially locking in their losses.”
“If they need the funds today, they may want to consider a HELOC instead,” says Odhrani. “We’ve had increased values in real estate significantly over the last few years. So a lot of individuals may actually have more equity in their home, and if they want to tap that equity for whatever reason, they can pull that equity out of their home,” he says. But home equity loans have downsides, too.
Either way, taking on more debt to pay off existing debt might make a challenging financial situation worse. Before making the decision, consider the pros and cons of how these loans work — as well as your unique financial situation — to decide which one (if either) might be better for you.
A home equity loan involves drawing on the equity in your home, while a 401(k) loan accesses cash in your retirement savings account. Both loans can be used for a variety of purposes.
Here’s more about their similarities and differences.
As a homeowner, you may qualify for a home equity loan or home equity line of credit (HELOC).
“Home equity loans are basically loans against the equity of your home,” explains ODhrani.
Most banks require a loan-to-value (LTV) ratio of 80% to 85% to borrow against your home’s equity, meaning that you must hold at least 15% or 20% equity in your home. If you owe $200,000 on your mortgage and your home is worth $300,000, for instance, your equity would be about 33% or one third.
To draw on your home’s equity, you typically have two options: a home equity loan or a HELOC.
A home equity loan works similarly to other installment loans. You usually get a lump sum upfront at a fixed rate that you pay off with monthly payments.
A home equity line of credit, or HELOC, on the other hand, works like a credit card. You can draw on it as needed and pay it off as you go. A HELOC may have variable rates which could increase over time.
With responsible use, a HELOC could function as an emergency fund.
A 401(k) loan involves withdrawing funds from your employer-sponsored retirement account.
“A 401(k) loan is a loan against your 401(k) retirement account,” says Dan Green, president of Homebuyer.com, a digital mortgage lender. “A person’s ability to withdraw a 401(k) loan is going to depend on their plan administrator. It may or may not be an option, depending on your employer and your plan.”
Note that a 401(k) loan is not the same as making an early withdrawal, which triggers a 10% penalty and a potential tax bill, as well. If your plan’s administrator allows a 401(k) loan, you can borrow up to 50% of your account value or $50,000, whichever is lower.
You’ll typically pay the loan back over a period of five years with interest, though some plans offer longer terms. Unlike other types of loans, however, you won’t pay interest to a bank, but rather pay it back into your own account. A 401(k) loan also isn’t a typical loan because you don’t have to pass a credit check to qualify.
A HELOC or home equity loan has both pros and cons to consider before you borrow.
On the pro side, home equity loans can be a more affordable option than some other types of loans due to their relatively low interest rates.
If you opt for a HELOC, you may also appreciate the flexibility of drawing on funds if and when you need them. Depending on how much equity you have in your home, you may be able to borrow a large amount. And if you’re using the funds to update your house, you could get a tax break, as well.
“If you’re using the funds for home renovations, any interest paid on the home equity loan can be tax deductible,” says Odhrani.
All that said, drawing on your home equity can involve a lengthy application, which may not be ideal if you need funds fast.
“A home equity line of credit can take time, because the banks have to go through a traditional lending process, which is going to include a credit check and income check,” Odhrani says.
You may also have to pay fees, such as an appraisal fee or closing costs.
“The closing fee is not going to be as high as with traditional mortgages, but certainly the bank may have some type of processing fee.”
The most important con of borrowing a loan against your home is that you risk losing your house if you can’t make payments.
Relatively low interest rates
Potentially high borrowing amount
Tax deduction for home renovation projects
Fees, such as home appraisal and closing costs
Potentially lengthy application process
Risk of foreclosure if you fall behind on payments
As with any loan product, there are benefits and drawbacks. Here’s what to consider with a 401(k) loan.
A 401(k) loan may be an appealing option if you’re looking for fast funds. Unlike a traditional loan, you don’t have to go through a credit check to take out a 401(k) loan, since you’re borrowing your own money. You’ll also end up paying interest back to your own account, which could help offset any losses you experience from divesting your money. Plus, there’s no prepayment penalty if you’re able to pay your loan back faster, according to Odhrani.
Draining your retirement savings, however, could reduce your earning potential. The longer you keep your money in your account, the more you’re likely to earn over time due to compounding interest. If you withdraw that money, you could lower your return on investment and have less money in retirement.
If you’re taking out pre-tax money, furthermore, you could miss out on some tax advantages. You’ll pay your loan back with after-tax dollars, so you’ll end up missing out on the upfront tax break that traditional 401(k)s offer. There wouldn’t be any tax penalty if borrowing against a Roth 401(k), since your contributions would already be after-tax.
Another potential downside to consider is the consequences of leaving your employer. If you quit or get fired, your 401(k) loan may become due immediately. You’ll have to pay it back in full or risk triggering an early withdrawal penalty.
No credit check or other prequalification requirements
Interest is paid back to your own account
Typically fast application process
Borrowing limits
Potential to reduce your earning potential
Loan becomes due immediately if you leave your employer
The decision to borrow a home equity loan vs. 401(k) loan all comes to your personal circumstances. If you need to borrow more than $50,000, a home equity loan or HELOC may be the better option. With the stock market down, like it is right now, it does not make sense to borrow from your 401(k) until your investments have had time to bounce back.
Drawing on your 401(k) may make sense if you need the funds for a down payment on a home, says Odhrani. Some plan administrators offer repayment terms as long as 15 year for the purpose of a home purchase, he says. “If it’s for putting down a down payment to buy a home, then perhaps they could do a longer term on the 401(k) plan.”
A 401(k) loan also locks in your interest rate for the duration of your loan, which may be preferable to an adjustable-rate HELOC during today’s rising-rate climate. Setting up a HELOC, however, could make sense even if you don’t need the money today, says Green.
“One of the wonderful features of a home equity line of credit is that even after you’ve borrowed money and paid it off, the balance remains zero,” he says. “It’s there as an emergency valve. If you ever have a crisis or anything that causes you to be unable to work or earn an income, that line of credit still exists. The HELOC is still in place and can be drawn upon for living expenses.”
And unlike a 401(k) loan, drawing on your equity won’t jeopardize your long-term retirement goals, assuming you pay it back on time.
“When a homeowner uses a home equity loan or home equity line of credit, they’re not harming their future equity growth,” says Green. “They’re not robbing their future wealth creation. From a comparison standpoint, when there’s home equity, it’s generally a more sound financial choice — but not for everybody.”
Home equity loans and 401(k) loans are not your only options for borrowing money. While it’s always a good idea to be cautious before taking on debt, here are some other options worth considering:
If you’re looking to renovate your home, you may be able to take out a home renovation loan to finance the project.
“Mortgage lenders love to finance construction that’s going to improve the value of your house,” says Odhrani. “If a homeowner is considering a large project, there are mortgage loans specifically designed for home improvement.”
Another option is a cash-out refinance, which essentially involves replacing your current mortgage with a larger one and pocketing the difference. Odhrani says this option can be worthwhile if rates are low.
“The difficult part about a cash-out refinance is it’s market dependent,” he says. “When interest rates are low, cash out refinances can be terrific. In a rising mortgage rate environment, cash-out refinances can be cost prohibitive.”
Personal loans can also be used for a wide variety of purposes, and some lenders offer easy online applications with fast funding. However, you’ll need to have strong credit to get the best rates. Personal loans are typically installment loans; you’ll receive a lump sum upfront and pay it back over a set term with monthly payments.
You can also open or do a balance transfer to a credit card with a 0% promotional period to borrow money with no interest attached. But you’ll need to pay off the amount before the promo period ends, or you could get stuck with sky-high interest charges.
“That’s a slippery slope to go down,” warns Odhrani. “Generally the reason credit card companies offer those deals is because the majority of the people don’t pay those back. And then they’re stuck with a credit card at a 20% interest rate.”
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