If you are looking for cash to invest in real estate, pay down high-interest loans, complete a home improvement project, or pay off an emergency medical bill, you might be wondering which the better option is: borrowing from your 401k or your home equity via a loan or line of credit. The answer depends on how you plan to use the money, how much money you need, and how long it will take you to pay it back?
Each situation is unique and has different tax and financial implications. While many financial planners frown upon borrowing from your 401k unless it’s a last resort, you should consult with your own financial planner/tax advisor to discuss your options. There are both pros and cons to using a 401K to free up some money.
- Con: you could be losing out on the tax-deferred growth of your money and tax-deductible contributions. In addition, you will most likely have to pay back your 401(k) with interest, and that interest is paid with after-tax dollars.
- Con: In many cases, if you quit or lose your job, you’ll probably have to repay the entire borrowed amount within three months. If you can’t, there could be income tax owed and penalties on the money you
- Pro: A 401k loan may be easier to obtain than other types of loans because you are borrowing from yourself, so no application or credit check is required.
- Pro: You can usually borrow up to 50% of the account balance or $50,000 at a maximum. The repayment cycle is usually a maximum of 5 years, so you can replace the borrowed funds quickly.
Home Equity loans are only an option for homeowners who have over 20% equity in their property. Depending on what you plan to borrow the money for, you may be able to deduct the interest. You can read more on the new laws by CLICKING HERE. Like borrowing from your 401k, there are both pros and cons that you should consider and possibly talk to a tax or financial planner about to determine the best option.
- Con: Borrowing against your home will require you to pay interest and get approved. Although much less than a credit card, you will still have to pay interest and apply for approval – including a credit check. You may also have to pay additional closing and application fees.
- Con: If you default on your home equity payments, you may lose your home since it’s held as collateral. If you are unsure if you can handle the payments, this may be a risky option.
- Pro: The repayment period on a loan or line of credit can be much longer than a 401K. A repayment period can be as short as 5 years or as long as 20 years giving you time and lower payment amounts to repay the loan.
- Pro: You won’t have to pay any taxes or penalties to the IRS. When you borrow from your home’s equity, it’s strictly a loan with the bank. If you switch jobs or retire, there is no requirement to pay back the loan within 3 months or face penalties.
Borrowing money from a 401k or your home’s equity isn’t something that you should take lightly or do on a whim. If you find yourself in a position where you can’t repay the borrowed money, you may find that you are facing additional fees, penalties, or possibly the loss of your home. It’s always best to consult your tax or financial advisor to determine your best course of action should you find yourself in need of funds. If you have questions on how Litchfield Bancorp can help you plan for your future with an IRA, Home Equity Loan or Line of Credit, CD, or even a savings account – give us a call, we’d be happy to explain the many options available to you.
Paul A. McLaughlin, Jr
Executive Vice President, Chief Operating Officer