Financial trouble can happen to anyone. If you’re faced with bills your emergency fund won’t cover, you need an alternative way to get cash in hand. Or you may need a lump sum up front to take advantage of a major opportunity for your family.
You know you want to avoid predatory payday loans. But will you be better off borrowing from your retirement fund, or taking a loan against your home equity?
What is a 401(k) loan?
Many financial professionals emphasize the importance of leaving your retirement accounts alone until you’re retired. While this is sound advice much of the time, there are situations where taking money from your 401(k) can be the right decision.
How does borrowing from my 401(k) work?
The IRS and your employer determine the conditions for a loan. The IRS sets the maximum you can borrow: $50,000, or 50% of your balance, whichever is less. (Saved less than $20,000? You are still allowed to borrow up to $10,000.) Your spouse may need to sign that they agree to the loan.
In most plans, you can access the funds in a few days. Repayment is generally on a 5-year schedule, although often you can pay the loan off faster without incurring prepayment penalties. As long as you pay off the balance in time, you won’t pay taxes or penalties for accessing retirement funds early.
Can I take a loan against my 401(k)?
“Loan” is a bit of a misnomer when it comes to a 401(k). You’re taking money from your own account, so there isn’t really a lender/borrower relationship taking place. That’s why you won’t have to undergo a credit check first, and the loan won’t affect your debt-to-income ratio.
That said, you will follow certain rules that are similar to most loans, like following an amortized payment schedule (i.e., regular, fixed payments) and paying interest as you replenish your 401(k) savings.
Can I use a 401(k) loan to pay off debt?
Most people who consider a 401(k) loan are doing so because they’re in a precarious financial situation. You’re taking money meant for your future and using it to handle a current problem.
If you follow the repayment plan faithfully, and the loan is fairly small, you may not hurt your retirement progress. The interest helps compensate for stock market gains you missed out on in the short term. Meeting the requirements can keep you from having to pay taxes or penalties.
If you use 401(k) funds to pay off current debt and don’t pay the money back, though, the IRS will treat the withdrawal as income. You’ll have to pay taxes on the money you don’t pay back. If you’re younger than 59 ½, you’re looking at penalties for early distribution as well.
The risk of penalties, and the danger of being tempted to borrow from your 401(k) more often, leads many people to look for other avenues to borrow money they need.
What is a home equity loan?
A home equity loan works a lot like a second mortgage. As a refresher, your equity is the value of your home that you own. If you owe $200,000 on a $300,000 home, the $100,000 is your equity.
Home equity loan vs. HELOC
When you get a home equity loan, the lender will give you a lump sum, and you repay the loan plus interest on an amortized schedule. This is different from a HELOC, or home equity line of credit. With a HELOC, the lender sets a maximum amount you can spend, and you can borrow and repay multiple times, the way you would with a credit card. The downside of a HELOC is that the lender can freeze your access if they’re worried about your ability to repay, which can cut you off at a critical moment. The home equity loan gives you all the funds you plan to access up front.
What to consider before taking a home equity loan
Your credit, the amount of equity you hold, and your debt-to-income ratio all matter when you apply for a home equity loan. Lenders need to feel confident that you’ll be able to repay the money.
Taking out a home equity loan may put you at higher risk for foreclosure, since you are adding more debt to your home. Talk with a financial advisor to make sure you have a plan to stay on top of all your payments.
Generally speaking, you want to look for transparent, fair terms and low fees on any loan. Home equity loan rates can range from 3.74% to 11.99% APR, depending on the size of the loan and the borrower’s creditworthiness.
Finally, make sure you’ve considered all your options. Would a credit card cover the balance without putting debt on your house? Have you factored in home equity loan closing costs, which could add a 2%-5% fee to the loan amount?
Other ways to finance home equity
Home equity financing at Noah doesn’t work the same way as a typical home equity loan. You don’t pay monthly payments or interest. You’re a home equity partner, sharing the appreciation or depreciation of your home with a company (i.e., yours truly). Ready to pay the balance early? No problem, and no prepayment penalty.
Is a 401k loan a bad idea?
If all goes smoothly — your job is stable, and you make every payment on time — then a 401(k) loan can work well. Even the interest payments end up in your own account. The problem is that we all know life doesn’t always go according to plan, which is why you may have needed to consider the loan in the first place.
If you leave your job, either voluntarily or through a layoff, the 401(k) loan becomes due by the due date of your next tax return. Bad news if you’re unemployed and on the hook for a $30,000 loan!
Is a hardship distribution worth it?
If you’re experiencing “immediate and heavy financial need,” then you might be eligible for a hardship distribution. These distributions are meant to cover costs like medical bills, funeral expenses, tuition costs, or purchasing a principal residence that you couldn’t pay otherwise. You’re limited to withdrawing only as much as is necessary to meet the financial need. In most cases, you will have to pay income tax and an additional 10% of the withdrawal amount as a tax penalty.
The benefit of a hardship withdrawal is you won’t need to pay the money back. The downsides are:
- Taxes and penalties
- You won’t be eligible to contribute to your 401(k) again for 6 months
- You can only withdraw to cover the specified financial need. If you need extra money to handle unexpected childcare or other living expenses, you’ll have to look elsewhere.
Your best borrowing solution
Taking money from your retirement fund or home equity are both major decisions. You should always consider your choices carefully. If you want to avoid outside lenders, a 401(k) loan may be an attractive option. If you’re worried about damaging your retirement progress, a home equity loan might work better for you. And if amortized payments and interest rates sound daunting, an alternative home equity financing arrangement like a Home Value Investment from Noah might meet your needs.
The bottom line is to consult a financial professional who knows your situation, and always look for financing partners who offer fair, transparent terms that you can trust.