Comparing HELOCs and 401(k) Loans

Key takeaways

• A HELOC can be an option for long-term projects, when you can commit to an adjustable interest rate that will likely fluctuate over time.

• A 401(k) loan may be better for immediate goals. Generally, it must be repaid within five years.

• To determine which option is best for you of these two, consider the amount of equity in your home compared with the savings in your 401(k) plan in the context of your financial need.

The HELOC: using your home’s equity for cash

It’s important to start with the basics.

What is a Home Equity Line of Credit (HELOC)?

A HELOC is essentially a second mortgage providing cash in proportion to your home’s value. You may view it as a credit card tied to the amount of equity you have in your home. For example, you could borrow money from the HELOC and repay all or part of the balance monthly. In either case, a financial institution, such as a bank, is the lender.

Importantly, a HELOC usually comes with an adjustable interest rate. The lender will set a base rate and then add a markup depending on your creditworthiness. The fact that your rate is adjustable means that market conditions may cause the rate to increase or decrease over the life of the loan.

The lender is required to disclose a lifetime cap, though, and some lenders also provide a periodic cap. A lifetime cap limits how much your rate can change over time, while a periodic cap limits how much the rate can change in a given period.

The key is that the interest rate is negotiable. Do your due diligence. By shopping for different lenders, you can determine which ones provide the best rates.

How much can I get and how do I repay the loan?

A HELOC typically provides a significant amount of money, anywhere from $10,000 to $50,000 or more. To determine how much money you can get with a HELOC, you can perform two simple calculations.

With the total amount you can borrow in mind, you can also begin to envision how much your repayments might be. First, divide your HELOC between the draw period and the repayment period.

The draw period usually lasts around 10 years. During this time, you may borrow money from the HELOC by check, transfer or even a credit card linked to the account. The lender will only require that you pay interest payments during this period, but you may begin paying principal as well.

Once the draw period ends, the repayment period begins. You may no longer borrow against the line of credit but must repay the loan in monthly payments that include both principal and interest. This period typically lasts about 20 years.

What factors do lenders consider in making the decision on a HELOC?

While lenders vary, most will want to see:

• A credit score of 620 or higher

• A home value of at least 15% more than you owe

• A debt-to-income ratio at 40% or less

The 401(k) Loan: Lending Yourself Money

Similar to a HELOC, 401(k) loan also provides access to cash when you need it, but the 401(k) loan differs in several key respects.

First, you are withdrawing money – taking a loan – from your own retirement savings. Current law allows you to withdraw up to $50,000 or 50% of the assets, whichever is less, on a tax-free basis.

Second, the 401(k) loan also requires interest payments. However, this “interest” is paid into your 401(k) account.

Unlike a HELOC, a 401(k) loan withdraws money from your future retirement investments. While the thought of temporarily reallocating this money from the plan may seem unappealing, repaying the loan on time may have minimal impact on your retirement.

To repay the loan, you may set up payroll deductions from your wages. Though most 401(k) loans must be repaid within five years, you may repay faster with no prepayment penalty.

Is a HELOC or 401(k) Loan Best?

The decision whether to choose a HELOC or 401(k) loan depends on a variety of factors.

How much money do you need? The HELOC provides access to more money, but the loan requires an adjustable interest rate. There may also be a balloon payment payable at the loan’s conclusion.

How urgent is the need? A 401(k) loan provides cash as quickly as the retirement plan’s terms allow, while obtaining a HELOC requires a similar process as does applying for a mortgage, so can take some time.

Do you plan to move soon? After a first mortgage, the proceeds from the sale of your house will generally also cover any unpaid balance on the HELOC. If you sell before you repay the loan, you will ultimately have less money after the mortgage and HELOC are repaid to put toward your next home.

Do you plan to change jobs soon? Changing employers while your 401(k) is in repayment will have negative tax implications if you fail to repay the loan by the next taxable year.

Unlock Technologies’ home equity specialists are here for you

Whether to apply for a HELOC or to obtain a 401(k) loan is a personal financial decision that depends on your unique circumstances. Having a trusted partner with expertise in home equity funds in this process is essential. Unlock Technologies can be that trusted partner. We offer an alternative to loans called a home equity agreement (HEA) which might be a great option.

For more information, contact us today.