Equity financing vs. 401(k) loan: How to decide

When you need cash for home improvements, debt consolidation, or unexpected expenses, finding the right financing option can be challenging. However, if you have valuable assets to pledge as collateral, you may have more options—some with more favorable terms and rates. Two popular secured financing solutions are borrowing against your home's equity or tapping into a 401(k) retirement account.

‍

This post will explore the differences between home equity financing and 401(k) loans, including when each option may be a good fit. 

Home equity vs. 401k loan: an overview 

Home equity financing and 401(k) loans both involve borrowing against an asset—your home or retirement savings. However, each type of financing comes with distinct advantages and drawbacks that are crucial to weigh. 

‍

When comparing equity financing and 401(k) loans directly, consider: 

Home equity financing

When you’ve built sufficient equity in your property, you can leverage it for better rates and terms than other consumer debt products. There are many ways to tap into one’s health wealth—a home equity loan, home equity line of credit (HELOC), home equity investment (HEI), and cash out-refinance are just a few of the common ways. 

‍

Pros

• More flexibility: With so many products on the market, homeowners can find financing that aligns with their unique needs—whether a specific type of payout (lump sum, line of credit) or repayment terms (monthly payments, no monthly payments). 
• Possible tax deductions: Interest paid on home equity loans and HELOCs may be tax-deductible if you use the funds for home improvements.
• Longer repayment terms: Home equity financing offers longer repayment terms compared to 401(k) loans. 

‍

Cons:

• Higher borrowing costs: Tapping into your home wealth isn’t exactly free. Generally, homeowners have to cover closing costs, appraisal fees, and other charges—which can add up quickly.
• Stricter requirements: Lenders typically require a good credit score, a significant amount of equity, a low debt-to-income (DTI) ratio, and sufficient income to qualify. As a result, it can be harder to get approved for an equity product than a 401(k) loan. 
• Potential for negative equity: If your home value decreases, you could end up owing more than your home is worth, resulting in an underwater mortgage. This can make it challenging to sell the property or refinance your mortgage.
• Risk of foreclosure: Since your home is used as collateral, defaulting on the loan can lead to foreclosure. 

401(k) loan

A 401(k) loan allows you to borrow money from your nest egg. You can typically borrow up to $50,000 or 50% of your vested account balance, whichever is less. The loan is repaid with interest, usually through payroll deductions, over a 5-year term. 401(k) loans are not subject to an early withdrawal penalty unless you default on the loan. 

‍

Pros:

• No credit checks: 401(k) loans can be a lifeline to low-credit borrowers. There’s no underwriting process, so credit score and history do not impact eligibility. As an added bonus, taking out a 401(k) loan won’t impact your credit score either. 
• Fast funding: Because you're borrowing from yourself, the approval process is usually quick—you can get funded in just a few days.  
• Repay interest to yourself: Rather than paying interest to a lender, the interest you pay on a 401(k) loan goes back into your retirement account.

‍

Cons:

• No ability to refinance the loan: Unlike equity financing, a 401(k) loan can't be refinanced. This means you won't be able to extend the repayment period, pull more money from the account, or reduce the interest rate if your financial situation changes.
• No bankruptcy protection: 401(k) loans don't offer the same protection as other debts, so you'll still be obligated to repay the loan even if you file for bankruptcy.
• Potential to trigger early loan repayment: If you leave your job or face an unexpected layoff, you'll need to repay the loan by the tax filing deadline of the following year.
• Risk of retirement shortfall: The most severe risk of borrowing from your 401(k) is not having enough saved for your golden years. This could result in debt or force a major lifestyle change in retirement.    

Home equity loan vs. 401k loan

When a home equity loan makes sense: You want predictable monthly payments but need more cash than a 401(k) loan can provide or want a longer repayment period than 5 years. 

‍

Of all the equity financing products on the market, a home equity loan works most similarly to a 401(k) loan—you get a lump sum of cash in exchange for fixed monthly payments. 

• Loan amount: Up to $500K
• Requirements: 15% to 20% equity, a credit score of 620 or higher,  DTI of 43% or lower, sufficient income
• Funding: 2 to 4 weeks
• Repayment: Monthly payments; 5 to 30-year term

Home equity investment vs. 401K loan

When a home equity investment makes sense: You want access to a lump sum of cash without restricting your monthly cash flow. 

‍

With a home equity investment, you can get a single lump sum payout in exchange for a share of your home’s future appreciation. However, unlike most equity financing products—and 401(k) loans—there are no monthly payments. Instead, you repay your loan anytime during a 30-year term when you sell your home, refinance, or use another source of cash reserves.

• Loan amount: Up to $500K
• Requirements: 15% equity or higher, a credit score of 500 or higher, no DTI or income requirements
• Funding: 4 to 8 weeks
• Repayment: No monthly payments over a 30-year term

HELOC vs. 401k loan

When a HELOC makes sense: You want a flexible form of financing to cover ongoing expenses or projects with uncertain costs. 

‍

A home equity line of credit (HELOC) is a revolving line of credit that works similarly to a credit card. During the draw period, you can borrow funds as you need while only being responsible for interest payments. Once the repayment period begins, the remaining balance is converted into a principal-plus-interest loan with a variable interest rate.

• Loan amount: Up to $500K
• Requirements: 15% to 20% equity, a credit score of 680 or higher, a DTI of 43% or less, sufficient income 
• Funding: 2 to 6 weeks
• Repayment: Interest-only payments during the draw period; 20-year repayment term with monthly payments once the draw period ends

Cash-out refinance vs. 401(k) loan

When a cash-out refinance makes sense: You want to change the interest rate or terms of your current mortgage while still accessing cash.  

‍

A cash-out refinance replaces your existing mortgage with a new, larger loan and allows you to pocket the difference in cash. Since you're essentially getting a new mortgage, you'll get a new rate and terms. Therefore, a refinance only makes sense if you can secure better conditions. 

• Loan amount: Up to 80% of your home’s value
• Requirements: 20% equity or more, a credit score of 620 or higher, a DTI of 45% or less, sufficient income 
• Funding: 6 to 8 weeks
• Repayment: Standard mortgage repayment term, 15 to 30 years

401K loan vs. hardship withdrawal 

When a hardship withdrawal makes sense (honorable mention): You’re experiencing a financial hardship. 

‍

A hardship withdrawal allows you to take money from your 401(k) without repaying it—but only in the event of immediate and heavy financial need. 

‍

Unlike a 401(k) loan, a hardship withdrawal can be subject to an early withdrawal penalty and taxes. However, similar to a 401(k) loan, you risk permanently reducing your retirement savings if you don't make catch-up contributions. 

‍

Qualifying hardships include costs to avoid foreclosure or eviction, expenses for repairing your main residence due to damage from floods, fires, or earthquakes, out-of-pocket medical expenses not covered by insurance, funeral and burial expenses, educational expenses, and home purchasing costs associated with buying a primary residence. 

• Withdrawal amount: Enough to cover the hardship
• Requirements: A qualifying hardship; An eligible 401(k) plan
• Funding: A few business days

How to decide

Choosing between home equity financing and a 401(k) loan ultimately depends on your financial situation, goals, and risk tolerance.

‍

Home equity financing may be a good solution if you:

• Want to access a large amount of cash.
• Need a longer repayment term.
• Are seeking more flexible terms (a line of credit or no monthly payments).

‍

Alternatively, a 401(k) loan may be a good solution if you:

• Don't have the best financial health (low credit score, low income, or high DTI).
• Want access to cash without impacting your credit score.
• Are confident in your job stability. 

‍

Consider consulting with a financial advisor to explore all your options and choose the best solution for your circumstances.

Final thoughts

Deciding between home equity financing and a 401(k) loan requires careful consideration. Home equity financing offers the opportunity to borrow against the value of your home, often with lower interest rates and potential tax benefits. However, it comes with the risk of foreclosure if you're unable to repay. 

‍

On the other hand, a 401(k) loan allows quick access to funds without affecting your credit score, but it lacks bankruptcy protection can jeopardize your retirement savings. 

‍

Before deciding, assess your ability to repay, the purpose of the funds, and the potential long-term impact on your financial health. 

‍

If you’re a homeowner ready to tap into their equity, consider a Home Equity Investment with Point. You can accomplish your financial goals without taking on monthly payments. To prequalify, visit home.point.com.  

‍