Tapping into home equity vs. borrowing from your 401(k)

As you prepare to start your home renovation project, you're probably considering different borrowing options to help with costs. You may have heard of friends or family members borrowing from their 401(k) plans to pay large expenses. If you're wondering whether this is a viable option for you, consider the following information carefully before making a decision.

Depending on the type of 401(k) you have, you may be allowed to apply to your employer to borrow from it. Check any restrictions on how you can use the loan, such as only for education expenses, mortgage payments or medical expenses. Typically, 401(k) plans cap borrowing at half your vested balance or $50,000, whichever comes first. You will then have up to five years to repay whatever you borrowed plus interest. You may be thinking, 'It's my money. Why do I have to borrow it?' Since a 401(k) is designed to help you save for retirement, there are early withdrawal penalties if you don't pay back what you borrow within five years.

A 401(k) can seem like an attractive borrowing option as there is the potential for a lower interest rate, a quick turnaround, no need for credit approval and the fact that any interest is paid back into your account, not a lending institution. However, there are several disadvantages to consider:

• Double taxation: The income you initially deposit into a 401(k) plan is pre-tax. If you borrow from it, you will be using your current taxed income to pay it back. Plus, you will still have to pay taxes on the money you withdraw once you're in retirement.
• Limited job mobility: If you take out a loan from your 401(k), you have up to five years to repay it unless you leave your job for any reason. Leaving your job gives you 60 days to repay your loan in full or else it will be treated as a withdrawal, forcing you to pay the income tax and 10% early withdrawal penalty. If you are unsure about your current job status, taking out a 401(k) loan would not be a financially sound option.
• Significant impact on your savings: 401(k) plans are designed to help you prepare for a period in life when you will not be earning a steady income. Once the money is taken out of your account, it isn't accruing interest and growing with the market. 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.

Borrowing against your 401(k) plan should be carefully considered vs. alternative options. There are other ways to afford a home renovation that present less risk to your current income and future plans. A home equity loan borrows against the equity built in your home. Home equity can be accessed in the form of a loan or a line of credit.

If you are a planning a full-scale remodel, a home equity loan might be the best choice as it can cover the large up-front costs of such a project. However, if you are remodeling over a longer stretch of time, a home equity line of credit (HELOC) might be a better choice since it has more flexible repayment terms and a revolving credit line.