Home Equity Loans Have Advantages Over 401(K) Loans

Equity loans lack the penalties and tax problems associated with retirement loans

Anytime anyone takes out a loan, they seek out the best deal. After all, no one is eager to pay more in interest and fees than he or she has to. And anyone who has a lot of debt, be it credit card debt or a student loan, would be wise to consolidate that debt

into a smaller, less expensive payment plan. One such source of funds would be to borrow from a 401(K) fund, which most employed persons can obtain through their place of work. Since the interest rate on Federally funded student loans increased July 1, 2005, many who missed the deadline may be wondering - Is a 401(K) loan a good debt consolidation option?

We have previously pointed out the advantages of home equity loans over 401(K) loans. The interest on funds borrowed against a 401(K) account is not tax deductible, and the removal of principal from the fund, even temporarily, can hinder the fund’s performance for decades to come. The money isn’t just lost for the duration of the payment schedule; the money that the fund could have earned during that time is lost forever. There are other reasons why borrowing against your home may be a better choice than borrowing against your retirement, and the reasons are sound.

The 401(K) option, on its surface, is a tempting one. There is usually no credit check; you are borrowing the money from yourself. For the same reason, the interest rate is usually favorable, typically running just a point or two above the prime rate. These are certainly advantages over alternative sources of funds. The disadvantages are pretty significant, however. Money invested in a retirement account is pretax money. When you borrow against it, the repayments are made with after-tax money, effectively increasing the loan principal. Worse, is what happens should the borrower lose his or her job. At that time, under Federal law, the entire balance must be repaid immediately!  For most people, the sudden burden of having to repay in full would be catastrophic. Failure to repay in full causes the full sum to be treated for tax purposes as a distribution, and it will be treated as income and subject to both state and Federal taxes. Even worse, a 10% penalty will be applied. As the job market is currently somewhat precarious, this disadvantage could be significant for most borrowers.

Borrowing from a tax-deferred 401(K) account is seldom a good choice for debt consolidation. The tax disadvantages, the threat of immediate repayment and/or additional tax and penalties make this type of loan rather unappealing. Debtors who have existing student loans would probably be better off keeping them, as the rate for student loans is more favorable than other types of loans and the interest is tax deductible. Others would be better off seeking a home equity loan or line of credit, as they offer better terms, fewer risks, and they won’t harm your plans for a pleasant retirement.