Home Equity loan? 401(K) loan? Which should you choose?

A home equity loan may offer advantages.

As a homeowner, you’ve always wanted a patio, and you have finally decided to build one. Now you can enjoy those afternoon barbecues and the enjoyment of a little fresh air. But you don’t have the cash handy with which to build that patio. How will you fund this purchase? Like most people, you will have to take out a loan, but what type of loan? A home equity loan would work well, as mortgage rates

are currently near historic lows. And perhaps, if you’re going to do it yourself, an open-ended home equity line of credit (HELOC) would work well, instead of a standard term loan.

Then you have a thought - “I have a 401(K) plan at work, and I have a lot of money invested there. I can borrow money from my 401(K) plan, get good terms on the loan, and pay back interest to myself!” That might be a better idea than a home equity loan from a bank and paying interest to them, right?

It would appear at first glance that borrowing against your 401(K) money might be a better idea than a home equity loan. Interest rates are good for either type of loan, but with the 401(K) loan, you pay yourself the interest. Isn’t that a good idea? Why or why not?

There are several reasons why it may be better to borrow against the home, rather than from retirement savings:

• Americans tend not to save much for retirement, so anything that takes away from retirement savings may not be wise. The last thing a retiree wants is to have to live off of a diet of soup. People want to enjoy their retirement, and that takes money. Borrowing against it can be risky.
• It is possible that the 401(K) account is earning interest at a rate that exceeds the interest rate on a home equity loan. If that’s the case, then the borrower will want the 401(K) to continue earning money, rather than to interrupt that process by borrowing against the account’s principal. If that is the case, leave the 401(K) account alone, and borrow against the home.
• The nature of compounding interest makes borrowing against the 401(K) account particularly risky. Even if the homeowner pays back the money, with interest, the total, once paid back, will be less than if the money had been left in the account in the first place. And that loss of earned interest cannot be made up. It’s lost forever.
• The interest on a home equity loan or line of credit is tax deductible, which represents a huge bonus. The interest is deductible from Federal income tax for loans of up to   $100,000. The interest on a 401(K) loan is not tax deductible.

There are certainly some situations where it may be advantageous to borrow from retirement savings, rather than against one’s home. One such situation might be one where the interest rate on the home equity loan is substantially higher than the interest rate on the 401(K) loan. Under prevailing market conditions, that isn’t the case, but these things change with time. Anyone with questions as to which type of loan works best for their particular case might do well to discuss the matter with a tax advisor or financial planner.