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Home Equity

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

A home equity line of credit lets homeowners borrow money using their home equity. Borrowers might seek a HELOC to renovate their homes, consolidate higher-rate debt, fund emergency expenses, or make other significant expenditures. 

In contrast, a 401(k) loan allows individuals to borrow from their retirement savings. Borrowers might seek this type of loan if they are experiencing a financial emergency. These loans don’t require any credit or income checks, so the borrower could receive the funds more quickly in comparison to a HELOC. 

Read on to learn more about HELOCs vs. 401(k) loans and when to consider each type of loan.

What is a home equity line of credit (HELOC)? 

A home equity line of credit (HELOC) is a type of financing that allows people to borrow money against the equity they have in their home. Home equity is the difference between the property’s current market value and the current balance of any loans against the property (e.g., mortgages). 

HELOCs are revolving lines of credit that allow you to use and repay the funds repeatedly. You are approved for a set credit limit based on your home equity. Unlike a credit card or line of credit, which has no end date for use unless you close the account, the HELOC can be used and repaid as much as needed only during the draw period—typically five to 10 years.

HELOCs can be used for many purposes, like home improvements, debt consolidation, or paying for major expenses. Interest on HELOCs may be tax-deductible if the funds are used for home renovations or improvements, but it’s important to consult a tax advisor for specific details on tax deductions.

Since HELOCs are secured by a home, lenders view them as less risky than other financing, like unsecured personal loans. You may get a lower rate and a larger loan amount with a HELOC, but you risk losing your home if you fail to repay it. So, carefully consider if it’s right for you before proceeding. 

Pros

  • Flexible access to funds

    HELOCs offer a flexible, revolving line of credit that can be used and repaid multiple times. 

  • Potentially lower interest rates

    They may have lower interest rates than other consumer loans because your home is used as collateral. 

  • Versatile use of funds

    HELOC funds can be used for many purposes, such as home improvements, debt consolidation, or emergencies, providing spending versatility.

Cons

  • Risk of losing home

    Defaulting on payments could lead to foreclosure, risking the loss of your home since it serves as collateral for the HELOC.

  • Inconsistent payments

    Similar to a credit card or other revolving line of credit, the monthly payments on a HELOC can vary depending on the interest rate environment, leading to potential unpredictability in repayment amounts.

  • Potential overspending

    Since it’s a revolving line of credit, HELOCs might lead to overspending, increased debt, and financial strain if not managed prudently.

What is a 401(k) loan?

A 401(k) loan is a loan taken from your own 401(k) retirement savings account. It allows you to borrow a portion of the funds accumulated in your 401(k) plan for a specified period, typically no more than 50% of the vested account balance or $50,000, the lesser of these amounts.

Unlike other loans, you’re borrowing money from yourself with a 401(k) loan, so it doesn’t affect your credit score. You’re simply taking money out of your 401(k) retirement plan and agreeing to repay yourself the amount you borrowed plus interest in a short term, typically no more than five years. 

If you don’t repay the loan as agreed, the balance of your 401(k) loan can be treated as a taxable distribution by the IRS. If this happens, you might also need to pay a 10% early distribution tax. Plus, if you leave your job, you may need to repay the 401(k) loan fully, or if not paid in full, it is treated as taxable income for the year. 

It’s generally best to explore other borrowing options before considering a 401(k) loan since you’re putting your retirement savings at risk. Before getting a 401(k) loan, make sure you fully understand the terms and potential consequences. 

Pros

  • Accessible borrowing

    They offer relatively easy access to funds without a credit check or the typical qualification process, as you’re borrowing from your own retirement savings.

  • Lower interest rates

    Generally, 401(k) loans have lower interest rates than other types of loans, with the interest payments going back into your own retirement account.

  • No impact on credit score

    Since it’s not a traditional loan, borrowing from your 401(k) does not affect your credit score.

Cons

  • Potential impact on retirement savings

    Taking out a loan may diminish the growth potential of your retirement savings as the borrowed amount is not invested during the loan period.

  • Risks if you leave your job

    If you leave your job, the outstanding balance might need to be repaid within a short timeframe, risking penalties or taxes if not managed correctly.

  • Possible tax implications and penalties

    If the loan isn’t repaid according to the plan’s terms, it might be considered an early withdrawal, subjecting you to income taxes and potentially a 10% penalty.

HELOC vs. 401(k) loan rates and terms

DetailHELOC401(k) loan
Interest ratesVariable and fixedVariable
Repayment termsUp to 20 – 30 yearsUp to 5 years
EligibilityEquity in a home, good credit, low DTI ratioFunds in an eligible 401(k) retirement account
FeesOrigination fees, title fees, appraisal feesOrigination or maintenance fees
CollateralResidential propertyNone

401(k) loan vs. HELOC: Interest rates and repayment terms

The interest rates on HELOCs are typically variable during its initial five to 10-year draw period when the loan acts like an open-ended revolving line of credit that can be repeatedly used and repaid. At the draw period’s end, the HELOC enters its repayment period, which may last 20 to 25 years. 

During the repayment period, a HELOC acts like a closed-ended loan with fixed payments of principal and interest on the outstanding balance. The interest rate typically converts to a fixed rate during the repayment period, and the loan repayment terms are similar to a mortgage. 

Your monthly payment for a HELOC and a 401(k) loan will include interest. All the interest you pay on a HELOC goes to your lender. Conversely, the interest on a 401(k) loan is added to the balance of your 401(k) retirement account. 

A 401(k) retirement account is meant for long-term investment growth. When you take a 401(k) loan, the borrowed funds are no longer part of the investment, potentially reducing the account’s growth. To compensate for some of this lost growth, the interest on the 401(k) loan is added to the account. 

401(k) loan vs. HELOC: Eligibility differences

The HELOC eligibility requirements are similar to a mortgage’s. You need to have equity in your home (usually at least 15% to 20%). Plus, you’ll need to show you have a good credit score (generally at least 620) and a reasonable debt-to-income (DTI) ratio (often not more than 43%). 

Conversely, 401(k) loans don’t have credit requirements since the borrower’s retirement savings are used to fund the loan. Instead, employment status and tenure with the company are more critical factors. Plus, the borrower needs enough vested savings in the 401(k) for the loan.

Regarding ease of qualification, 401(k) loans might be more accessible because they do not rely on credit or income eligibility. However, the availability and amount you can borrow are tied to the savings within the 401(k) and the rules of the specific plan, so this can be more difficult.

For both loan types, the terms and eligibility requirements can vary. It’s crucial to understand the terms, conditions, and implications of each loan before applying. Always consider the impact on your finances and future retirement plans before deciding to borrow from a 401(k) or through a HELOC.

How to decide between a 401(k) loan and HELOC

Choosing between a 401(k) loan versus a HELOC involves considering the urgency and timing of your need, the purpose of the funds, and your ability to repay the loan. If the funding need is urgent, a 401(k) loan might be better due to its quicker approval process. A HELOC might take longer to process as it involves property evaluations, credit checks, and income documentation.

Understanding the specific loan purpose is also crucial. If the funds are for significant home improvements, a HELOC is likely more appropriate, and you may be able to deduct some of the interest on your tax return

Your ability to repay is also important. HELOCs often involve long repayment terms. While this may lead to a smaller payment, you’ll also be in debt longer. Conversely, 401(k) loans often need to be quickly repaid and may need to be repaid in full immediately if the borrower leaves their job. 

When choosing between a 401(k) loan and a HELOC, some of the questions you might ask are:

  • What’s the immediate need? If you need to quickly borrow a small amount, a 401(k) loan may be the right choice. Conversely, if you need a larger loan amount or want to access the funds repeatedly on demand, a HELOC may be a better option. 
  • What’s the impact on your future plans? Consider how borrowing from your home or retirement account will affect your long-term goals. For example, will the loan set back your retirement plans or keep you in debt longer than you desire?
  • How does the loan repayment affect your budget? Think about which loan offers the best or most manageable repayment terms. Whichever option you choose, it’s essential to ensure you can reasonably afford the payment or repay the loan. 
  • Are you eligible for the loan? Sometimes, your circumstances will dictate the choice. If you don’t have home equity or good credit, a HELOC isn’t an option. Similarly, you can’t get a 401(k) loan if you don’t have enough vested retirement savings.

Situations when you might choose a 401(k) loan vs. a HELOC include the following:

If you  HELOC or 401(k) loan?
Need funds immediately and don’t have time for a credit or income evaluation.401(k) loan
Don’t want to put your retirement savings at risk.HELOC
Don’t want to put your home equity at risk.401(k) loan
Plan to use the funds to significantly improve your home.HELOC
Can quickly repay the loan in five years or less. 401(k) loan
Want or need up to 30 years to repay the loan.HELOC

Ultimately, choosing between a 401(k) loan and a HELOC involves evaluating your immediate financial need, home equity, retirement plans, and loan purpose. The type of loan suitable for each person will vary depending on their unique circumstances. 

For this reason, it’s crucial to carefully consider the implications of each loan before making a decision. Since this decision can have a significant effect on your financial plans and stability, it may be a good idea to consult with a financial advisor before you choose which loan to get. 

Long-term effects of HELOC vs. 401(k) loan

If you need money fast and have enough funds available in your 401(k) retirement account, a 401(k) loan may be a quick way to get funded in the short term. Getting a HELOC approved and funded could take much longer since your lender needs to evaluate your credit, income, and property value. 

Although it’s faster to get approved, if you don’t repay the 401(k) loan as agreed, the IRS may treat the loan as a distribution, and you may need to pay extra taxes. Plus, the funds you withdrew for the 401(k) are no longer invested. So, you’re potentially losing out on long-term account growth. 

If the balance of your retirement account doesn’t grow at the desired rate, you may need to delay your retirement plans. Similarly, with a home equity loan, you’re spending some of the savings you built up in your home. Depending on the repayment term, it could take years to recoup these savings. 

As with any financial decision, it’s important to carefully consider how the loan you choose will affect your short- and long-term plans and goals. By weighing the pros and cons of each loan and evaluating its impact on your goals, you’ll be equipping yourself to make a good financial decision. 

FAQ

What happens if I leave my job while repaying a 401(k) loan?

If you leave your job while repaying a 401(k) loan, the outstanding balance often becomes due immediately. Failing to repay it immediately might result in the loan being treated as a distribution, subjecting you to income taxes and potentially a 10% early withdrawal penalty. 

This situation can significantly impact your retirement savings and financial well-being, so it’s crucial to plan for potential repayment challenges if you anticipate a job change while still carrying an outstanding balance on a 401(k) loan.

Can I refinance a HELOC or 401(k) loan?

Refinancing a HELOC is possible, but how you do this depends on the lender’s policies and your financial situation. One of the most common solutions is to refinance your mortgage and the outstanding HELOC balance into a new mortgage loan. 

Depending on your 401(k) plan, you may be able to “refinance” your 401(k) loan by replacing it with another 401(k) loan. You’ll need to speak with your plan provider to understand what, if any, options are available to you. 

What are the application processes like for both options?

The application process for a 401(k) loan involves contacting your employer’s retirement plan administrator or the financial institution managing the 401(k) plan. Generally, you’ll fill out loan paperwork and specify the amount you wish to borrow, following the 401(k) plan’s guidelines. 

Approval for a 401(k) loan doesn’t involve credit checks. For this reason, the process is usually straightforward, with the loan amount determined by your vested 401(k) balance.

In contrast, the application process for a HELOC starts by applying with a lender, often a bank or a credit union. Lenders generally assess your credit score, income, property value, and other factors to determine if you qualify. 

If the lender determines you’re pre-qualified for a HELOC, a property appraisal may be required to confirm the value of your home. The application and approval process can take much longer than a 401(k) loan due to HELOCs commonly requiring an extensive credit evaluation and property assessment.

How does either option affect my credit score?

A 401(k) loan doesn’t impact your credit score because it doesn’t involve a credit check. The loan is taken from your own retirement savings, and its repayment or non-repayment doesn’t get reported to credit bureaus. So, it won’t affect your credit score positively or negatively.

Conversely, a HELOC can impact your credit score. Applying for a HELOC can lead to a hard inquiry on your credit report, which can cause a slight, temporary decrease in your credit score. 

If you max out your HELOC credit limit, it can cause you to have a high credit utilization ratio, potentially impacting your credit score negatively. Conversely, timely and consistent payments on the HELOC can positively influence your credit score over time.

Are there restrictions on how I can use the funds from a 401(k) loan or HELOC?

How you plan to use the loan funds can affect your ability to get a 401(k) loan or HELOC and the repayment terms. For example, if you use the funds from a 401(k) loan to buy your primary residence, you may be able to repay the loan in more than the standard limit of five years.

Each HELOC lender will set its own rules and restrictions on how you can use the loan funds. Many lenders don’t place any restrictions on how you use the funds. Even so, it’s essential to use the funds responsibly since you’ll need to repay the amount you borrow with interest. 

How does the economic environment affect HELOC interest rates or 401(k) loan terms?

The economic environment can significantly affect HELOC interest rates and 401(k) loan terms. Economic growth tends to happen when interest rates are low. It’s more affordable to borrow money during these periods, meaning there are lower HELOC rates and more favorable 401(k) loan terms. 

Conversely, interest rates tend to be higher during slower economic environments, and it’s more expensive to borrow money. These periods are generally marked by higher HELOC rates and less favorable 401(k) loan terms.

Here are some factors that can affect the economic environment:

  • Inflation: Inflation is the rate at which prices for goods and services are rising. When inflation is high, it can erode the value of money, making people less willing to borrow money. This can lead to higher interest rates.
  • Unemployment: Unemployment is the percentage of people who are actively looking for work but are unable to find a job. When unemployment is high, it can lead to lower consumer spending, which can also lead to lower interest rates.
  • Gross domestic product (GDP): GDP is the total value of goods and services produced in a country in a given year. When GDP is growing, it suggests the economy is expanding, which can lead to lower interest rates.
  • Federal Reserve: The Federal Reserve is the central bank of the United States. It sets monetary policy, which can affect interest rates.

Notably, the economic environment is constantly changing, and it can be challenging to predict how it will affect interest rates and loan terms. However, by understanding the factors that can affect the economic environment, you can be better prepared to make sound financial decisions.