Using Home Equity vs. 401K Loan: Which is Better?
Whether you need funding for a long-term goal like higher education or to cover emergency home maintenance costs, taking out a loan is one possible route for accessing cash.
If some of your wealth is stored in your home or your 401K retirement savings, it’s possible to take out a loan against your assets.
So, when it comes to a 401k loan vs home equity, which is better?
In this brief guide, we’ll explore the differences between a home equity vs 401K loan. We’ll also discuss other home equity loan alternatives and options for accessing cash and claiming financial stability.
What is The Difference Between a 401K Loan and Home Equity Loan?
Both 401K loans and home equity loans allow you to borrow money against your current assets. However, they draw from different asset pools and each have a different loan term.
- A 401K loan takes money out of your employer-supported retirement plan or retirement savings account. Depending on your earnings, you’ll receive either half of the balance in your account (up to $50,000). Most people pay off their 401K loans in a loan repayment period of five years in scheduled installments or monthly payment.
- A home equity loan is a fixed rate loan based on the equity accumulated from your home. Your home equity can be calculated by subtracting any liens on your home (mortgage loan, HELOC or home equity line of credit, etc.) from its market value. It’s also called a second mortgage since it acts as a new, second lien on your home. You’ll often pay back a home equity loan within a set loan repayment period, typically around 10 to 20 years.
However, there are some substantial differences between these two ways to access cash.
Most notably, your interest rate for a home equity loan will be based on your financial history, including your income, credit score, and current debt balances. In contrast, a 401k loan does not entail a credit check, and the main criterion for qualification is adequate 401k savings.
So, which is right for you? Next, we’ll discuss the pros and cons of each loan type.
Pros and Cons of a 401K Loan
If you have substantial retirement savings and don’t want to go through a credit check or lengthy application process, a 401K loan can be intriguing.
Notable benefits of a 401K loan vs home equity include:
- Accessibility – You already have money in your 401K account, so pre-qualification procedures like credit checks aren’t necessary. This could make it an appealing option if your credit is less-than-ideal.
- Convenience – The application process for a 401(K) loan is quick, and loan repayments can be made as additional deductions from your paycheck.
- No traditional interest – While the loan must be repaid with interest, keep in mind that loan interest goes back into your retirement account.
However, there are also significant drawbacks.
- Diminished retirement savings – The money in your 401(K) is invested to grow over time. If you take money out, you’re also missing out on potential gains. Beyond this general rule-of-thumb, some employers may not allow you to make contributions or will not match funds while you have an outstanding loan.
- Potential tax penalties – If you lose or quit your job, the loan balance will be due. Failure to pay back the loan could impose tax penalties, particularly if you’re under the retirement age of 59 ½.
Pros and Cons of a Home Equity Loan
If you’re wary about touching your retirement savings, you may be interested in how to use home equity.
There are a few benefits to home equity loans:
- Lower interest rate – When you apply for your home equity loan, the bank will propose an interest rate. These rates are often lower than for credit cards and other kinds of debt.
- Possible tax deductions. If you use the loan to bolster the equity of your home—for example, redoing your kitchen or adding a deck—you may qualify for a tax credit on the loan interest.
- A longer repayment period – While your specific loan term may vary, you’ll usually have ten years or more to pay off your debt. You’ll make the same monthly payment every month and face no surprise fees when the bill is due.
Home equity loans can be convenient if you have a dependable income and know you can make the payments.
For this same reason, however, they may not be ideal for everyone. The drawbacks of home equity loans include:
- Fees – When applying for a home equity loan, you may need to pay for a home appraisal. There are also fees and a closing costs associated with the loan. These can add to your overall debt.
- Risk of foreclosure – Using your home as collateral makes home equity loans inherently risky. Factors like environmental disasters, weak housing markets, or an inability to make payments could lead to foreclosure proceedings.
Other Options Besides Home Equity and 401K loans
So when it comes to a home equity vs 401K loan, which is the better option?
Much of that depends on your circumstances and financial history.
- If you aren’t worried about depleting your retirement fund and think you could easily pay back the loan in five years, consider a 401K loan.
- If you need more than $50,000 and are confident you can comfortably continue making payments on your mortgage and other debt even in the event of job loss, a home equity loan may be a good option.
But while homeowners commonly use these tools, they aren’t the only options at your disposal.
As a homeowner, you can also consider:
- A HELOC line of credit (be sure to carefully compare a home equity loan vs. HELOC)
- Selling your home and using the profits to meet financial goals
- A sale-leaseback solution
A Path Forward to Financial Freedom
When paying for once-in-a-lifetime milestones, it’s important to take charge of your finances and explore all the options.
Sale-leaseback programs are designed to help homeowners unlock their equity without taking on additional debt. Through this solution, you can get the most out of your home by converting equity into cash, all while focusing on the things that matter most—a college education, a wedding, or making your dream business a reality.
Reach out to a financial advisor to learn more.
Whether you need funding for a long-term goal like higher education or to cover emergency home maintenance costs, taking out a loan is one possible route for accessing cash. If you are still unsure of your options for financing goals or the difference between home equity and a 401K loan, after reading this article, consult a financial advisor to discuss your options.
- Investopedia. Home Equity Loan Definition.
- Federal Trade Commission. Home Equity Loans and Credit Lines.
- Bankrate. The Pros and Cons of Taking Out a 401(K) Loan.
- Investopedia. 4 Reasons to Borrow From Your 401(K).