401(k) Loan vs HELOC: Which Loan Is Better in 2024?

Is it better to get a HELOC or 401(k) loan?

Trying to decide between a 401(k) loan vs HELOC? A HELOC is almost always better than a 401(k) loan. Both options let you borrow money “from yourself,” but they’re very different in practice.

A home equity line of credit (HELOC) borrows from your property value. By contrast, the money in your 401(k) is actively working for you by accruing interest over time. Cashing those funds out means a serious setback in your retirement savings.

As long as you can qualify for a HELOC, that’s likely to be your best option.

In this article (Skip to...)

• 401(k) loans
• Pros and cons of 401(k) loans
• HELOCs
• Pros and cons of HELOCs
• Comparing loan options
• How to choose
• Alternatives
• FAQ

What is a 401(k) loan?

A 401(k) loan is a type of loan that allows you to borrow money from your 401(k) retirement savings account. A 401(k) is a retirement plan typically offered by employers in the United States.

Each employer gets to set its program’s rules. Your employer and account provider may or may not allow loans and early withdrawals; for those that do, rules and loan terms can vary.

How do 401(k) loans work?

Assuming your plan administrator allows you to borrow from your 401(k) and have sufficient pre-tax funds saved, you can borrow up to 50% of your plan’s vested balance or $50,000, whichever is less. If your plan’s balance is less than $10,000, you may be able to borrow a larger proportion.

Borrowers must repay the loan, including interest, usually within five years. Repayments are made through payroll deductions. The interest charged on the loan is often lower compared to other loans, and it goes back into the borrower’s 401(k) account. If the loan is not repaid as agreed, it may be considered a distribution, subjecting the borrower to taxes and potential penalties.

Whatever your employer’s rules say, you must repay your debt in full within five years — unless you’re using the loan to buy a home, which must be your principal residence. And you must make at least one payment each quarter. If you fail to meet either of those requirements, the IRS will likely declare your loan a withdrawal, and you’ll get a large tax bill and have to pay early withdrawal penalties.

Pros and cons of 401(k) loans

If you’re debating between a HELOC or 401(k) loan, keep in mind that 401(k) loans generally offer just three key benefits over home equity lines of credit.

1. They tend to have ultra-low interest rates
2. They don’t require credit checks or other barriers to approval
3. They don’t require you to be a homeowner or have equity

When comparing a 401(k) loan or HELOC, it’s important to note that for most borrowers, the downsides of a 401(k) loan far outweigh the advantages. The major drawbacks of borrowing from your retirement account include:

• You typically can’t make any contributions to your 401(k) while you have an outstanding loan
• Your employer will also stop making contributions to your 401(k) while the loan is active
• You could end up with a substantial loss to your retirement income
• You may not be able to borrow as much as you could with a HELOC
• You could have higher monthly payments than with a HELOC due to the shorter repayment period
• You must receive a single lump sum. That’s less flexible than a HELOC’s line of credit
• You will pay interest on the full loan amount, not just on your balance

If you’re weighing whether to borrow from a 401(k) or HELOC, you might consider a 401(k) loan if a HELOC is unavailable due to insufficient equity or qualification challenges. Nevertheless, there are alternative solutions to consider that won’t compromise your retirement funds.

Alternatives to 401(k) loans

Managing your personal finances can be challenging when unforeseen expenses arise. Although a 401(k) loan may appear convenient, before opting for a 401(k) loan or HELOC, remember that you have other options.

1. Tapping into your IRA

If your retirement plan includes an Individual Retirement Account (IRA), you could consider this as an alternative. Some IRAs allow you to withdraw without penalty for specific purposes like a first-time home purchase or medical expenses, offering a level of flexibility in contrast to a 401(k).

2. Consider early withdrawals

Another alternative is an early withdrawal, but this option may come with financial drawbacks. If you withdraw funds before retirement age (59 ½), you might face income taxes on any gains, along with a potential 10% penalty. The exact penalties can depend on the nature of the hardship prompting the early withdrawal.

Despite the absence of repayment obligations, early withdrawals may significantly impact your retirement plan. The prime reason being they can diminish your retirement funds, affecting your future financial stability. Remember, these withdrawals are not tax deductible, which may further strain your finances.

3. Hardship distributions

A specific type of early withdrawal, known as hardship distribution, could be a potential option. The IRS defines a hardship distribution as funds withdrawn in response to an “immediate and heavy financial need.” This category covers specific circumstances, such as:

• Select medical expenses
• Costs associated with buying a principal home
• Tuition, fees, and education costs
• Preventing eviction or foreclosure
• Funeral and burial expenses
• Emergency home repairs for uninsured casualty losses

In these instances, you are not required to pay back the withdrawn amount. However, the term “hardship” can be subjective, and not all personal financial difficulties will qualify you for this type of withdrawal.

What is a HELOC?

A Home Equity Line of Credit (HELOC) is a type of loan that allows homeowners to access the equity in their homes. It can be used for various purposes, including debt consolidation and home improvement projects.

A HELOC provides a revolving line of credit, similar to a credit card, where borrowers can borrow and repay funds within a specified draw period. Interest is only charged on the amount borrowed, not the entire credit line. Repayment terms vary but often include a repayment period after the draw period ends.

How do HELOCs work?

A HELOC is typically considered a second mortgage, as it is secured by the borrower’s home. The amount that can be borrowed depends on the available equity in the property. The interest rates on a HELOC may fluctuate over time, as they are often variable and tied to the prime rate and other market conditions.

Just note that you won’t be able to borrow all your available equity. Most lenders set a maximum HELOC limit between 80% and 90% of the home’s appraised value. That means your HELOC amount and your primary home loan, when combined, can’t exceed 80%-90% of the property value.

When deciding between a HELOC vs 401(k) loan, it’s important to note that, like any loan, a HELOC carries risks. Failing to make timely payments can result in foreclosure and the loss of the home. Additionally, using a HELOC for debt consolidation may only be beneficial if the borrower maintains disciplined financial habits to avoid falling back into debt.

HELOC rates and payments

HELOCs are almost all variable-rate loans, meaning their rates go up and down in line with other interest rates. However, you may be able to fix the rate on some or all of your balance.

HELOCs have two phases. During the initial draw phase, you can borrow, repay, and borrow again as often as you want, making them exceptionally flexible. And you pay the interest only on your loan balance each month.

Eventually, the repayment phase kicks in. Then you can’t borrow anymore and have to zero your loan balance over a set period. However, lenders offer a wide array of options when it comes to the length of each phase. So you can choose to give yourself plenty of time to comfortably repay your loan. There’s no five-year limit, as there is for 401(k) loans.

Pros and cons of HELOCs

If you’re debating between a 401(k) loan vs HELOC, keep in mind that HELOCs provide multiple benefits for homeowners looking for versatile funding options:

• Flexibility to borrow only what you need, when you need it
• Potentially lower interest rates than other types of loans
• Interest may be tax-deductible if used for home improvements (consult a tax advisor)
• Longer repayment periods, often up to 20 years
• Access to a revolving line of credit during the draw period

When weighing a HELOC vs 401(k) loan, it’s crucial to understand that HELOCs also come with potential drawbacks that borrowers should carefully consider:

• Variable interest rates, which can increase over time
• Risk of foreclosure if you default on payments
• Reduces home equity
• May have closing costs and fees
• Draw period followed by repayment period, which can lead to payment shock
• Potential for overspending due to easy access to funds

Pros and cons of home equity loans

When considering a home equity loan vs 401(k) loan, consider that home equity loans typically provide:

• Lower interest rates
• Potential tax-deductible interest
• Fixed monthly payments
• Useful for large expenses like home improvements

When comparing a home equity loan vs borrowing from a 401(k), it’s also important to consider the drawbacks. Home equity loans often come with these disadvantages:

• Carry the risk of foreclosure if unable to repay
• Reduce home equity
• Closing costs and fees
• Long repayment period

Comparison: 401(k) loan vs HELOC vs home equity loan

When considering your borrowing options, it’s important to understand the key differences between a 401(k) loan vs home equity loan, as well as whether to borrow from a 401(k) or HELOC. This table below will help you make the best choice for your personal finances.

When to consider a 401(k) loan, HELOC, or home equity loan

When facing financial needs or pursuing goals like home improvements or debt consolidation, it’s crucial to understand your borrowing options. Let’s explore whether to borrow from a 401(k) or HELOC, and compare 401(k) loans vs home equity loans to help you make an informed decision.

HELOC vs 401(k) loan

A HELOC is almost always better than a 401(k) loan for several reasons:

• You are not risking your future comfort and security during retirement
• You can take longer to repay your loan than with a 401(k) loan, making each monthly payment smaller
• The loan is flexible; you can borrow, repay, and reborrow at will during the HELOC draw period
• You pay interest only on your outstanding balance; if you borrow nothing, you pay nothing
• You may be able to fix your mortgage rate on some or all of your HELOC borrowing
• You’ll likely enjoy a lower interest rate compared with most other types of loans

Example: Sarah needs $40,000 for home renovations. Her options:

• HELOC: 8.5% variable rate, 10-year draw period, 20-year repayment period
• 401(k) loan: 9.5% fixed rate, 5-year repayment period

The HELOC offers Sarah more flexibility with a longer repayment term and doesn’t impact her retirement savings. However, it comes at a higher total interest cost of $76,893.60 over the loan term compared to $10,631.60 for the 401(k) loan over five years.

The choice between a 401(k) loan vs HELOC depends on whether Sarah prioritizes lower monthly payments and flexibility or minimizing total interest paid.

401(k) loan vs home equity loan

When deciding between a home equity loan or 401(k) loan, consider that while a 401(k) loan can seem attractive due to its ease of access, a home equity loan often provides more benefits:

• Home equity loans typically offer extended repayment periods.
• Interest on home equity loans may be tax-deductible when used for home improvements.
• Home equity loans usually come with fixed interest rates.
• Unlike 401(k) loans, home equity loans don’t impact your retirement savings.

Example: John needs $50,000 for debt consolidation. His options:

• Home equity loan: 8.5% fixed rate, 15-year term, $494 monthly payment
• 401(k) loan: 9.5% fixed rate, 5-year term, $1,049 monthly payment

Despite the higher interest rate, the home equity loan offers John lower monthly payments and doesn’t disrupt his retirement savings. However, the 401(k) loan is cheaper in terms of total interest paid, costing $12,940 in interest payments compared to $38,920 for the home equity loan.

Additional factors to consider

When considering whether to choose a 401(k) loan vs home equity loan, remember:

• HELOCs and home equity loans require homeownership and sufficient home equity.
• A good credit score (usually 680-700 or higher) is typically necessary.
• 401(k) loans should be a last resort, used only when other affordable options aren’t available.
• Consult a financial advisor to evaluate your specific situation and explore all loan options before making a decision.

Ultimately, while 401(k) loans can provide quick access to funds, HELOCs and home equity loans often offer more favorable terms and don’t compromise your retirement security.

However, there’s really only one situation in which borrowing from your 401(k) makes sense. And that’s when you have a serious need for cash and no other way to access it affordably. Perhaps your credit score is too low or you already have too many existing debts to get a different type of loan.

If you absolutely need to borrow from your 401(k), be sure not to borrow more than what’s required. And try to pay it back as quickly as you can so you can resume making deposits and benefiting from your employers’ matching program (if available).

Alternative loan options

If you’re weighing a HELOC vs 401(k) loan or comparing a 401(k) loan or home equity loan due to concerns about risking your home equity or retirement savings, you might consider these alternative borrowing options:

• Cash-out refinance: Cash-out refinancing involves replacing your existing mortgage with a new one that has a higher loan amount. The difference between the new loan and your old mortgage is received as a lump sum cash payout. This option allows you to tap into your home equity while potentially securing a lower interest rate and extending the repayment period. However, it involves origination fees and closing costs and may reset the terms of your mortgage.
• Personal loans: Personal loans are unsecured loans that can be used for various purposes, including debt consolidation or home improvements. They are typically based on your creditworthiness and income rather than your home equity. Personal loans offer fixed rates and predictable monthly payments over a specified term. While they may have higher interest rates compared to home equity options, they don’t put your home at risk.
• Credit cards: Credit cards can be used for smaller expenses, but they generally have higher interest rates compared to other loan options. If you’re considering using credit cards for debt consolidation or home improvements, ensure you have a solid plan to pay off the balance quickly to avoid accumulating excessive interest charges.

Think carefully before you borrow or use any product. Do you absolutely need the funds? And are you choosing the least costly option available to you?

FAQ: 401(k) loan vs HELOC

HELOC or borrow from 401(k): Your next steps

For HELOCs and home equity loans, the only way you can be sure you’re choosing the least costly option is to get quotes from multiple lenders. Then compare the annual percentage rates (APRs) you’re offered. APRs reflect the loan costs as well as the raw interest rate.

A mortgage lender can help you evaluate your options and compare costs to find the best loan type for you. They can also help you weigh the pros and cons of a 401(k) loan vs HELOC to determine which option might be more suitable for your financial situation. Ready to get started?