Home equity vs. 401(k) loan: What you need to consider

By Citizens Staff

Key takeaways

A 401(k) loan could decrease your retirement savings and cause problems if you change jobs before you can repay it.
Many people use their home equity for large expenses to save money on interest and to take advantage of longer repayment terms.
A home equity line of credit (HELOC) allows you to borrow money as needed up to your credit limit. It may be a good option for when you need to manage a home improvement project over time or cover ongoing expenses.

Sometimes life throws you a curveball. You may find yourself needing some extra cash for a home renovation project, unexpected medical expenses, education costs, a wedding or one of many other reasons. If you need to pay for a large expense, you're probably considering different ways to finance it. Using the equity in your home and 401(k) loans are two options. We'll discuss both to help you select the right funding for your needs.

How to borrow from your 401(k)

You may be able to borrow a portion of your 401(k)-account balance, typically up to 50% or $50,000, whichever is less. To qualify, your 401(k) must permit loans, you must meet the eligibility requirements, and your employer must also approve the loan. You will then have up to five years to repay it with interest.

401(k) loans can be used for many purposes, but your employer may have restrictions. They may only approve loans for educational expenses, medical expenses or something else, for example.

Taking out a 401(k) loan is usually a better choice than making an early withdrawal. There is a significant penalty for an early withdrawal, and it will also reduce your savings. With a 401(k) loan, you repay the money you borrow with interest, which helps you replenish your retirement savings.

The pros and cons of borrowing from your 401(k)

A 401(k) loan can seem like an attractive financing option since you are essentially borrowing from yourself. The potential negatives may outweigh the benefits, however, in certain situations.

401(k) loan pros

Low interest rates: 401(k) loans typically have lower interest rates than other borrowing options, like credit cards and personal loans. Also, the interest you pay goes into your retirement account instead of to a lending institution.
Quick loan approvals: 401(k) loan applications are simple, and approvals may even be automated, which allows you to get your funds quickly.
No credit check required: Because 401(k) loans are secured by the balance in your account, credit checks aren't required. This allows you to qualify for a loan if you don't have a strong credit score.

401(k) loan cons

Double taxation: 401(k) contributions are not taxed. Income tax is paid on the money in your account when you start making withdrawals in retirement. 401(k) loans are repaid with money that has already been taxed, however, which means the money will be taxed again when you retire and make withdrawals.
Limits job mobility: If you have a 401(k) loan and leave your job, you will be required to repay it in full within 60 days. If you are unable to repay it, the funds will be treated as a withdrawal, and you will have to pay income tax on it and pay an early withdrawal penalty.
Reduces your retirement savings: A 401(k) loan will reduce your retirement savings, which could impact your long-term financial security. It's unlikely you'll be able to grow your balance to where it would have been had you not borrowed from it, even if you repay the funds quickly.

Although a 401(k) loan is a quick and easy way to borrow, you could run into some problems if you need to change jobs or if it decreases your retirement savings. For these reasons, it should only be used when you need to borrow and it's the only option you have.

How to use your home equity to borrow money

Home equity refers to the amount of ownership you have in your home. It's based on the current value of your home, not the purchase price. For example, if your home is valued at $300,000 and you owe $200,000 on your mortgage, your home equity is $100,000. There are two ways you can use home equity to borrow money — with a home equity loan or with a home equity line of credit (HELOC).

Home equity loans

Home equity loans are traditional loans with fixed interest rates that are backed by the equity in your home. You borrow a lump sum and then repay it with fixed monthly payments over a term of 5 to 15 years.

HELOCs

HELOCs are revolving lines of credit with variable interest rates that are also backed by the equity in your home. They are similar to credit cards in how they work, and you can draw money as needed up to your credit limit during the draw period, which may be up to 10 years. Your available credit is replenished when you repay the money you borrowed.

The pros and cons of using your home equity to borrow money

Are you considering borrowing against your home equity vs. a 401(k) loan? Using your home equity to borrow money is a flexible and affordable way to finance a major expense. There are usually no restrictions on what the funds can be used for, and you don't have to ask for your employer's permission to borrow.

Borrowing against home equity pros

Low interest rates: Home equity loans and HELOCs are secured because your home is used as collateral. Secured loans and lines of credit typically have lower interest rates than those that are unsecured.
Larger loan amounts and lines of credit: You may be able to borrow more with your home equity than with other loan types or credit cards. Your line of credit or loan amount depends on how much equity you have and other factors.
Long repayment terms: Home equity loans typically have repayment terms of 5 to 15 years, depending on the amount borrowed. A HELOC’s repayment period is typically 10-20 years, which kicks in after the draw period, which is usually 5-10 years.

Borrowing against home equity cons

Closing costs: A lot of home equity loans and HELOC’s have closing costs that can range from 2% to 5% of the loan amount. If you borrow $20,000, for example, the closing costs could be $400 to $1,000. However, there are some lenders, like Citizens, who offer HELOCs with no closing costs or application fees.^†
Impact on home equity: If you decide to sell your home before you have repaid your home equity loan or HELOC, you’ll need to pay off the remaining balance along with any accrued interest during the closing – just like any other mortgage.
Foreclosure risk: If you fall behind on your payments or default, it could result in a home foreclosure because your home is used as collateral.

Using your home equity to borrow money can often be a better option than a 401(k) loan because it doesn't negatively affect your retirement savings. You can also change jobs without being required to quickly repay the loan.

Consider the advantages of a HELOC

When considering borrowing against your home equity vs. a 401(k) loan, a HELOC may be a solid choice. It could help you save on interest because you can draw money as needed instead of repaying a lump sum. If you are remodeling your kitchen, for example, you could draw money at various stages to complete different parts of the project — like the cabinets, countertops, flooring and new appliances.

Be sure to carefully consider all your options before you apply for a loan. Borrowing money with the equity in your home is an affordable option for financing large expenses, but other loans may be better suited for smaller amounts.

Do you have home equity and need quick financing? Get money in as little as two weeks with a Citizens FastLine® HELOC.

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† For additional information, please click the † symbols throughout this page to view our home equity line of credit disclosures.

Home Equity Lines of Credit are offered and originated by Citizens Bank, N.A. (NMLS ID#433960)

Disclaimer: The information contained herein is for informational purposes only as a service to the public and is not legal advice or a substitute for legal counsel. You should do your own research and/or contact your own legal or tax advisor for assistance with questions you may have on the information contained herein.