3 Sources of Fast Cash Besides Your 401K

By Carrie Kirby on 2 November 2016 0 comments

You're in the middle of a remodeling project, and due to unforeseen circumstances, your money runs out early. You can't live with a half-completed kitchen, but you can't pay for it to be finished right now. And while you have plenty of equity in your home and a healthy retirement account, there's nothing in the bank.

Once you've decided to take out a loan, what is the best source of funds? Are 401K loans or borrowing against home equity ever a good idea?

"The best option is of course is your parents," says financial planner Bob Goldman. But if you can't tap the bank of mom and dad for an interest-free loan, your other best options are probably a cash-out refinance, a secondary mortgage, a home equity line of credit, or a 401K loan. Deciding which one to use requires some number crunching and a hard look at your personal situation, including your job security, your repayment timeline, and your will power.

Cash-Out Refinance

Mortgage interest rates are at historic lows, making now a good time to think about refinancing. When you refinance your home, you are replacing your current loan with a brand-new one, preferably at a better interest rate. Depending on how much equity you have in your home, you may have the option of borrowing cash at the time of the refinance — so that once all the paperwork is done, you'll have a lump sum in your bank account, which you will pay back as part of your regular mortgage payments.

Cash-Out Refinance Pros

A cash-out refinance has a lot going for it.

1. Low Rate

A mortgage often offers the lowest interest rate you can get, outside of promotional offers. And because rates are near historic lows, a lot of people feel that locking in a low rate now for a long loan term is a good call.

2. Low Payments

Because the payback period will be long — generally 30 years — a cash-out refi can ease the month-to-month strain of repayment, especially if you are able to lower the interest rate. If you are paying, say, 5% interest on your mortgage and you are able to refinance to 3.77%, you could add $50,000 to your loan principal while only adding about $100 a month to your payment.

3. No Surprises

As long as you take out a fixed-rate mortgage, you know what your payment will be for the life of the loan.

4. Tax Benefit

The interest you pay on your refinanced mortgage will be tax deductible. According to this mortgage tax savings calculator, if you add $50,000 to a $200,000 mortgage, you could save about $10,000 in taxes over the life of the loan, more or less depending on your tax bracket and the interest rate.

Cash-Out Refinance Cons

As great as a cash-out refinance is, it's not free money.

1. Risk

Your home is on the line. For most people, your house is your biggest asset, and putting it even at slight risk isn't a decision to take lightly. Far too many homeowners ended up losing their homes during the financial crisis when they overborrowed against their homes' value.

2. Fees

You have to pay closing costs, which average about $1,800 on a $200,000 loan.

3. Qualifying

You need good credit, especially for the best rates.

4. Starting Over

One thing people often overlook when refinancing, Goldman says, is that taking out a new 30-year loan pushes out the date when you'll be done paying off your mortgage. "You reset the clock on your mortgage," Goldman says. "You're back to Day One, where you're paying mostly interest."

What's the Total Cost of a Cash-Out Refinance?

Getting $50,000 this way would cost a typical borrower about $30,000 in interest and fees over the course of 30 years at current interest rates. I calculated this using a mortgage calculator to compare the lifetime cost of borrowing $200,000 versus $250,000, keeping in mind that getting cash out usually increases your interest rate by about ⅛ percent. I added $2,000 in closing costs and subtracted $10,000 in tax savings.

Home Equity Loan

A home-equity loan is so much like a mortgage that it's also known as a "second mortgage." The only difference between this and a cash-out refinance is that instead of replacing your original mortgage with a new one, you're adding a second loan also using your home as collateral. But everything else — the fact that you're taking a fixed amount of money, usually at a set rate, and paying it back over time — remains the same.

Home Equity Loan Pros

A second mortgage is a lot like a cash out refi, but with some wrinkles.

1. Simplicity

If you have a great mortgage rate on your home and don't want to change it, this is a way to borrow money while leaving your original mortgage untouched.

2. Shorter Time

If you have a 30-year mortgage but only want to borrow money for five to 15 years, you can do that with a home-equity loan.

3. Tax Benefit

Like a regular mortgage, your interest is usually tax deductible.

Home Equity Loan Cons

You'll need to be sure you understand the downsides of this kind of loan.

1. Interest Rate

Data from Bankrate shows home equity loans averaging at least a percentage point higher than mortgage rates.

2. Qualifying

You need good credit, especially for the best rates.

What's the Total Cost of a home-equity loan?

About $11,000 in interest and fees to borrow $50,000 for 10 years.

If you borrow $50,000 for 10 years through a second mortgage, you would pay about $13,000 interest over the life of the loan. Closing costs would be similar to a mortgage refinance, about $2,000. During that time, the mortgage interest deduction could save you about $4,000 in taxes.

Home Equity Line of Credit

Like a home-equity loan, a Home Equity Line of Credit (HELOC) is a secondary loan that piggybacks on your original loan. As with both types of loans discussed above, your home is still the collateral. The big difference is that while you can get cash out of a first or second mortgage only once, a HELOC is a revolving credit line, meaning that you don't need to know upfront exactly how much you'll need over the life of the loan. You can borrow $10,000 this month for a new furnace, and then $5,000 another month for landscaping.

HELOC Pros

The key advantage of a HELOC is its flexibility, but there are others to consider, too.

1. Borrowing Flexibility

Experts recommend these loans for ongoing expenses such as college tuition, rather than a home repair that you might pay for in a lump sum. If you do a refinance and then realize you'll need to borrow more money, you would need to pay closing costs all over again and might not be able to lock in the same rate.

2. Tax Benefit

Like the above loans, the interest paid on a HELOC is usually tax deductible.

3. Payment Flexibility

Your loan may allow you to pay interest-only for a certain amount of time.

HELOC Cons

As with the other home loans discussed, a HELOC carries some costs.

1. Risk

Like both the above loans, your home is on the line.

2. Rate Uncertainty

Since HELOCs often have variable interest rates, and rates are currently at historic lows, they will probably rise in the future. By law, how much the rates go up is capped — the lender must tell you the maximum potential rate when you take out the loan. The average HELOC rate at the moment is similar to home equity rates, or around a point above 30-year-mortgage rates.

3. Balloon Payments

Many HELOCs start out requiring only interest payments, then expect the borrower to pay the whole principal at the end. If you can't, Goldman said, you'll probably end up refinancing the debt into a much longer, more expensive loan.

4. Temptation

As with credit cards, having a line of credit to draw on can encourage overspending. "It's one thing to be on a diet when the refrigerator is empty. It's another thing to be on a diet when the freezer is full of ice cream," Goldman said. "You'll have this money available to you, so it will require a great deal of discipline to manage it."

5. Qualifying

You need good credit to qualify, especially for the best rates.

6. Fees

You may or may not have to pay closing costs, and may be charged ongoing fees such as annual maintenance fees and transaction fees.

What's the Total Cost of a HELOC?

Rough estimate: $9,500. It's more difficult to predict the lifetime cost of a HELOC if the rate is adjustable and the amount you owe on it varies, but this adjustable mortgage calculator figures that with steady, modest interest increases, a 10-year, $50,000 HELOC could cost $14,000 in interest. Fees vary, but if your bank charges a $50 annual fee, that adds $500 to the cost. Subtract an estimated $5,000 in tax savings.

Borrowing From Your 401K

If you have a 401K retirement account through your employer, you might have the option of "borrowing" from its balance. This is not a true loan, since the money in your 401K already belongs to you. In reality, what you're doing is getting an exemption from early withdrawal penalties and taxation, as long as you promise to put the money back and pay yourself an interest rate — generally one to two percentage points above the prime rate.

Despite all those articles out there warning you to avoid borrowing from your 401K, Goldman says this can be a good option if conditions are right.

"If I had my choice, I would definitely borrow from a 401K," he said. Although neither borrowing against your home or borrowing against your retirement are without risk, at least if you fail to pay back your 401K loan, you're not out on the street.

401K Loan Pros

This type of loan may be the easiest of all to get — it's your money, after all!

1. Qualifying

You don't need good credit to qualify for a good rate, making this an attractive option for folks who wouldn't qualify for a regular loan.

2. Risk

If you fail to pay it back, it won't affect your credit score or send collection agents after you. You also don't risk having your home repossessed.

3. No Bank

You pay the interest to yourself, which is sort of like not paying interest at all.

401K Loan Cons

There are not too many downsides to borrowing from your 401K — but there's a big one you should think very carefully about.

1. Risk to Your Retirement Savings

Failure to pay back this loan could cause great harm to your retirement account. For instance, if your employment ends for any reason, the loan becomes due immediately. If you can't pay it, it's converted to a distribution, which means that you pay taxes and (if you are under age 59 ½, a 10% penalty). So you're basically stuck at your job while you have a 401K loan out; you might end up turning down a new job offer if you don't have the cash to pay the loan. Worse, if you get fired and can't pay it, you could be out of a lot of money in addition to having no job.

2. Double Taxation

The disadvantage that people often don't consider with 401K loans is that while you filled your account with pretax dollars, you repay the loan with post-tax dollars — but you'll have to pay tax again on the money when you eventually withdraw it in retirement. How much you can get: While home loans let you borrow a percentage of your home equity, 401K loans are capped at $50,000 or half your balance, whichever is less.

What's the Total Cost of Borrowing From Your 401K?

It would vary greatly depending on how close you are to retirement and how well the market does during your loan. Using this calculator, I came up with an estimated cost of $25,000 in lost investment and tax benefits to borrow $50,000 for five years. That assumes your retirement account would have $10,246 less in it at the time of retirement, and that you lost out on $15,000 worth of tax benefits.

Bottom Line

By these calculations, home equity loans tend to be less costly than mortgage refis or 401K loans. You should run the numbers using your own circumstances before making that determination for yourself.

Cost is not the only thing to consider when deciding how to borrow. There's also the degree of risk involved, and the amount of time you have to pay the money back. Again, personal circumstances will dictate your choice: If you only need the money for a short time, for instance, until your stock options vest next year, a 401K loan might be the best choice. If you can't afford to pay the loan off in the near-term, the refinance gives you the most time.

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