NEW YORK (CNN/Money) -
My wife and I recently bought $40,000 worth of windows and are considering two ways of paying for them. One is to take out a four-year loan from my 401(k) at a 5.7 percent interest rate. The other is to borrow against our home equity line of credit at a rate of prime minus 0.25 percent (which would make the rate 5.25 percent).
I like the idea of the 401(k) loan because I'll be paying interest to myself. But my wife says we should go with the home equity line. Who do you think is right?
-- A.W., Bloomfield, New Jersey
Sorry, big guy, but I've got to side with the little woman on this one. I know that a lot of people get hung up on this idea of paying interest to themselves, but I don't think that's the right way to think about this question.
The real issue is: Once you pay off the loan, which option leaves you better off than you were before?
For a number of reasons -- ranging from the fact that interest on the home equity line is usually tax deductible to the fact that you would expect 401(k) assets invested in a blend of stocks and bonds to earn more than the rate on the 401(k) loan -- that's likely to be the home equity line. But the best way to see this is by doing a quick example comparing the two options.
The 401(k) option
Let's assume you're starting with a 401(k) balance of $100,000 and contemplating a $40,000 loan. I'm going to use the figures you've provided -- a 5.7 percent rate on the 401(k) loan and a 5.25 percent rate on the home equity loan -- and I'm also going to assume that over the four years it takes to repay the loan that the other investments in your 401(k) earn an annual return of 6 percent.
One more thing: although I would definitely recommend that you continue to make your regular contributions to your 401(k) regardless of whether you opt for the 401(k) or home equity loan, for simplicity's sake I'm going to leave additional contributions out of this example.
The contributions wouldn't affect the outcome anyway, as long as you're consistent -- that is, you would continue making contributions or stop them whether you borrowed from the 401(k) or against the home equity line.
The table below summarizes how things would play out given the scenario described above. In the case of borrowing from the 401(k), the table first shows the $40,000 loan initially reducing your 401(k) balance and then details how much that balance would grow over the next four years as you repaid the loan and also earned a 6 percent return on the loan payments themselves as they flowed into your 401(k) account.
The home equity line of credit option
In the case of the home equity line, your 401(k) starting balance remains the same and earns the 6 percent annual return over the next four years.
You also get two additional benefits, though: a small amount of savings because you're shelling out $8 less each month for the home equity loan payment vs. what you'd pay for the 401(k) loan; and you're picking up some pretty significant tax savings since interest on home equity lines is typically tax deductible, while interest on 401(k) loans is not.
As you can see, the bottom line for the home equity option is larger than that of the 401(k) loan. Which means that when you consider what you have in your 401(k) plus the benefit of a smaller loan payment and the tax savings, you're better off going with the home equity line.
In fact, you're even a better off than the table shows. Why? Because the interest you paid to yourself in the 401(k) came from after-tax dollars that will be taxed again when you withdraw money from your 401(k). So you'll have paid tax twice on that money.
This double-whammy -- which is a negative for the 401(k) loan option -- isn't reflected in the table. What's more, I haven't allowed for any investment value for the tax savings, which is money that you could plow into investments such as your 401(k), if you're not already maxing out, or into an IRA or taxable investments. The return on those tax savings would tilt things even more in the home equity line's favor.
I purposely made the return assumption 6 percent because I didn't want to "cook the books" in favor of the 401(k). In fact, I think a 401(k) account invested in a blend of stocks and bonds would stand a decent chance of doing better, which would make the home equity option even more attractive. At an 8 percent annual return on 401(k) assets, for example, the home equity line comes out ahead by $1,758 ($136,049 vs. $134,291), even before factoring in the savings of lower monthly payments and the tax benefit.
And just in case you were wondering, the home equity line still comes out ahead even if the rate on the 401(k) loan and the home equity loan are the same.
I'd argue that there are other reasons to go with the home equity line as well. One is that if you leave your job or are laid off with a 401(k) loan outstanding, most employers require you to repay the loan within 60 days. If you can't do that, the loan balance is considered a withdrawal, which would be subject to income tax and, possibly, a 10 percent premature withdrawal penalty.
Also, while I've assumed you'll repay the home equity line over four years, most home equity lines give you much more maneuvering room, allowing you to pay interest only for many years and pay the loan off quickly or stretch out the payments for a long time.
Unless you're borrowing from your 401(k) to buy your home, 401(k) loans limit the repayment period to no more than five years. And while 401(k) loans typically charge an interest rate of one to two percentage pints over prime, you can usually find home equity lines that charge prime or even less.
There may be another factor to consider. Some 401(k) plans don't allow anyone with a loan outstanding to make regular contributions to the plan until that loan is repaid. If that's the case for your plan, you would be stunting the growth of your nest egg, not to mention giving up a valuable tax break by foregoing contributions during the time it takes to repay your 401(k) loan.
Could it ever work?
Is there ever a circumstance in which the 401(k) option might be the better way to go? Sure. If you had to pay a much higher borrowing rate for a home equity line or other loan outside the 401(k) than the rate you could get from your 401(k) plan, the lower payment might outweigh the advantages of borrowing outside your plan. Similarly, if you knew in advance that the return on your 401(k) assets was going to be considerably lower than the rate you'll pay on the 401(k) loan, then borrowing against the 401(k) could be the better deal.
The reason is that in such a case the interest you're paying on the assets you borrowed would be getting a higher return than those assets would receive if they'd been left in the plan. But I don't think it's reasonable to assume you can predict what rate of return you will earn over the next four years.
And, of course, there's always the possibility that a 401(k) loan might be the only option you have, perhaps because you've got a lousy credit rating or because you don't have time to go through a conventional lending process.
So I think this is one of those cases where you're going to have to just admit to your wife that she was right and you were wrong. But there is a way to take some of the sting out of that admission. Casually mention to your wife that, as part of your regular review of abstruse financial publications, you happened to notice in IRS Publication 523: Selling Your Home that your investment in windows can probably be added to the basis of your home, a move that would decrease your taxable gain, if any, when you eventually sell.
I suspect your wife will see right through this ploy, but you can at least walk away with the pretense of having salvaged some vestige of your financial pride.