HELOC vs. 401(k) loan: How to choose

If you need to borrow money for home improvement projects, debt consolidation, or other large expenses, you probably want the lowest rates to save money on interest. That’s why home equity lines of credit (HELOCs) are such popular tools among homeowners; lenders typically charge competitive rates on HELOCs. 

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However, one financing option may have even lower rates: 401(k) loans. Many people aren’t aware that you can borrow from your 401(k), but if you’re eligible, you can often borrow money and pay yourself interest. However, this comes with caveats. Let’s take a look at how each option works and when it might be a good choice. 

How a HELOC works

A HELOC is a flexible funding option similar to a credit card. It allows you to borrow money as needed against a pre-set credit limit for a period of five to 10 years (the “draw period”), during which time you’ll only need to make interest-only payments on money you’ve borrowed. You can pay back those borrowed funds to replenish your available credit. 

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Once you reach the end of the draw period, your access to borrowing more money stops, and you’ll enter the “repayment period,” where you pay everything back over 10 to 20 years. 

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A HELOC is a type of second mortgage because it uses your home as collateral for the debt. In fact, most lenders only allow you to borrow up to 80% of your home’s value, minus any other mortgage debts. This allows lenders to offer low interest rates, but it also means that if you default, your lender can foreclose on your home. 

How a 401(k) loan works

If you have a 401(k) plan, you may be able to borrow some of the funds you’ve saved and repay them to yourself over time. Loan amounts are limited to $50,000 or 50% of your current 401(k) balance, whichever is smaller. 

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You’ll repay the loan through a payroll deduction from your regular paychecks. Most plans offer one choice of term length, typically five years. Another big benefit is the interest rate: often just 1% to 2% above the prime rate.

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Taking out a 401(k) loan comes with some serious strings attached, however. If you leave your current employer, you’ll immediately owe the remaining outstanding balance. Failing to repay may incur tax penalties as an early withdrawal. (You may qualify for a penalty waiver for a hardship withdrawal in some cases).

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Many plans don’t allow you to keep contributing to your 401(k) while you’re repaying your loan. Losing out on five years of contributions can hinder your ability to save for retirement, especially if you’d be missing out on employer matching. Plus, while it’s true that you pay interest to yourself, it’s generally less than what you’d be earning if you kept your money invested in the stock market. 

HELOC vs. 401(k) loan 

Sometimes, it helps to focus on a few key points of difference when comparing equity financing options. 

Requirements

Qualifying for a HELOC is generally more difficult than getting approved for a 401(k) loan, assuming that you have access to both. 

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When you apply for a HELOC, lenders will check your credit, income, and other debts, as well as your home and mortgage details. You’ll generally need at least 20% equity in your home to qualify and a credit score of 620 or higher. 

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A 401(k) loan doesn’t check any of those things, by contrast, making it a more accessible option for people who have bad credit. The only requirement with a 401(k) loan is an employer who allows you to borrow against your account balance. 

Funding limits and payout method

You can potentially borrow more money — and more often — with a HELOC compared to a 401(k) loan, depending on how much home equity you have. 

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Lenders often allow you to borrow up to 80% of your home’s mortgage-free balance when using a HELOC. If you have a paid-off home valued at $100,000, for example, that could translate into a flexible HELOC credit limit of $80,000. 

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The most you would ever be able to borrow from a 401(k) loan, by contrast, is $50,000. This is disbursed as a lump sum, and once paid out, you aren’t eligible for more funding until you repay your first 401(k) loan.

Financing Costs

The specific fees and charges vary by lender and 401(k) plan administrator, but typically, 401(k) loans cost less than HELOCs — especially if you keep an outstanding balance on your HELOC. 

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Most 401(k) loans charge an origination fee and/or a periodic maintenance fee, as determined by your employer. A HELOC often comes with these fees, too, as well as closing costs more generally associated with getting a mortgage, such as an appraisal, county recording fee, title search, credit report, etc.

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Interest rates are often lower with 401(k) loans. If you’re looking to complete home repairs or upgrades, however, HELOCs have one major cost advantage over 401(k) loans: the interest you pay may be tax deductible.  

Repayment

The way you repay a HELOC vs. a 401(k) loan is very different. A 401(k) loan is repaid more like a standard term loan. You’ll make steady payments until the balance is repaid in full, typically in five years. These payments are made via payroll deduction.

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A HELOC, on the other hand, can introduce more uncertainty into your budget. Your payment amount can change depending on how much money you borrow, what interest rates are currently sitting at, and what phase of the loan you’re in (repayment vs. draw). 

Risks

Both options come with risks; it’s just a matter of choosing which risks are more tolerable. 

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The main risk of taking out a HELOC is defaulting on the loan, in which case you could lose your home. HELOC payments are variable, which can make it harder to manage your finance. 

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There are also many risks of using a 401(k) loan, too. You may be forced to repay your loan quicker than you’d planned if you separate from your employer, and if you can’t, you may owe early withdrawal penalties and taxes. Losing out on retirement savings can leave you farther behind in your golden years. 

When to consider using your 401(k) loan vs. a HELOC

Although there are many downsides to using 401(k) loans, there are times when the benefits outweigh the risks. Consider whether these factors may apply to you:

• You have a stable job.
• You need a lump sum of cash.
• You’re not able to qualify for favorable HELOC terms.
• You don’t yet have much home equity available in your home.

Alternatives to consider

You’re not just limited to choosing between a HELOC vs. 401(k) loan if you need funds. Here are some other common options people use in different situations:

Personal loan

If you’re not keen on borrowing against your home equity and you’re looking for a more traditional loan (as opposed to a line of credit), consider using a personal loan. They’re much quicker to get since your home isn’t involved in the underwriting process. The interest rates can be higher, however, especially if your credit isn’t the best. 

Home equity loan

A home equity loan is a good option if you’re looking to borrow a large sum all at once, but would prefer to use your home equity to help you secure a lower rate. Home equity loans feature similar requirements and underwriting as HELOCs, but they’re repaid via steady monthly payments at a fixed rate over a term of one to 20 years. 

Cash-out refinance

Depending on your mortgage rate, a cash-out refinance may be a good option. A cash-out refinance allows you to replace your current mortgage, taking out additional funds at the same time. A cash-out refinance can help you roll your debts into one payment. 

Home equity investment

If you wish to avoid monthly payments, a home equity investment (HEI) may be a viable option. You’ll get funds in exchange for a share of your home’s future value. Repayment will be due in up to 30 years. Qualification requirements are more flexible than a HELOC. 

Final thoughts

It can be tough to decide between a HELOC vs. a 401(k) loan. A 401(k) loan can work wonderfully in the right circumstances, or have long-lasting consequences. A HELOC can be a great fit, or can put your home at risk. 

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Speak to a financial advisor who works on a fiduciary basis, who can help you make an informed decision. If you can’t afford one, consider reaching out to the National Foundation for Credit Counseling to get a referral to a free or low-cost credit counselor who can help. 

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