View Full Version : 401K or Home Equity loan?

08-21-2005, 09:56 PM
I want to buy a lot to eventually build on in 5 to 7 years.
I can borrow up to 50,000 on my 401K and pay it back over 10yrs @ 5.5%. Or a Home equity loan for 50,000 same rate and same time frame.
Which is the best way to go? I feel I will be able to pay them off sooner than 10 yrs because I will be retiring in 10 Yrs.

08-21-2005, 10:13 PM
Why not both? If you know what you are doing, you can make more than 5.5% on your investments in your sleep.

08-21-2005, 10:40 PM
For most people, probably the home equity loan makes more sense. Though the correct answer depends on many factors, which you haven't provided.

First, you hold legal title to the home. So borrowing money from the bank, secured by equity in your home, doesn't change that. You control the home whether you borrow against the equity or not, so in a sense, the equity is not doing anything sitting there, except lowering your monthly payments. By lowering your mortgage balance and mortgage payment, it lowers your risk of defaulting on the mortgage if you lose your job or lose your arm or leg in an accident and cannot work. But this is no problem as long as you don't borrow more than you can safely repay, even in a worst case scenario.

Second, you pay 6% interest, but you get a tax break on mortgage interest, so effectively you are only paying 4% or so. In other words, the government subsidizes home loan costs, by giving you a discount on your taxes. It is paying you to take out a mortgage or home equity loan. So why not.

Third, 6% is basically the lowest interest rate we have seen in 40 years. Money is cheap. If filet mignon steak were selling for $1 a pound instead of $15 a pound, and if you enjoy steak, why not buy a lot when it's cheap??? If money is cheap, and you can invest it at a higher return, borrow as much as you safely can.

Fourth, inflation favors the borrower. With inflation at 2 to 3% and rising, you are paying back the loan with inflated dollars. Over 15 years or 30 years, the money you pay back is worth much less than the money you borrowed. So your real interest rate is 4% after tax deductions, and perhaps only 1-2% after considering the inflation premium. So you are really only paying 1-2% for the money.

Go to any inflation calculator. If the bank pays you $100 today and you pay the bank $100 in 30 years, you are way ahead, which is why the bank has to add an inflation premium just to stay even.

Fifth, if you use the money as a down payment on more land, and if the land goes up in value, and if you have leveraged your investment, say paying 50 K to buy a 150K piece of land, AND IF THE LAND APPRECIATES IN VALUE, then you may earn more than 2% return on your money, considering leverage.

Sixth, the return you make on the land is tax-deferred and possibly may be tax free depending on whether you eventually live on the land. Land typically at least keeps pace with inflation. If you live in a desirable city like SFO or NYC or LA, then you will beat inflation and stocks, because your annual return is tax deferred or tax free over 30 years.

Seventh, compare this to the 401K. If money is in your 401K and if you can invest in an S&P 500 index fund or if you can pick your own stocks with a discount broker (after you leave your job and roll over into an IRA account), then you are looking at average annual returns of 8-10% historically. Assuming you don't pick bad stocks and lose it all. Which is possible. (Stocks for the Long Run, Siegel)

So your stock returns, tax-deferred for 20-30 years in your 401K, you would theoretically be giving up. If you borrow money from your 401 K, then you only will get the real estate return on that 50K from the vacant lot. And you lose the potential stock returns.

Look at it this way. You can have a home and 50K in stocks.

Or you can have a home with higher payments, 50K in land, and 50K in stocks.

Which is best? Depends if you can make the higher payments, and depends if you can pick good stocks.

If you would lose 100% of the money investing in bad mutual funds or picking bad stocks, you may be better off using the 401 K money, so you don't do anything stupid with it.

If you cannot make the higher mortgage payments, don't take out the home equity loan and risk losing your home if you cannot make the payments and lose your job during the next recession. And the recession will come. And worst case scenarios sometime do come true, for each of us.

Many choices depend on the individual. Should a person go to college, go to vocational school, or become a dancer or open his own business. Depends on the person, their abilities and aptitudes, etc.

What kind of dog should I buy? Big, small, hairy, short-haired, noisy, quiet, old, young. It depends.

But anyway, with financial considerations, at least you can isolate certain economic variables. But there are lots of qualitative variables to consider too.

If you invest in the raw land and lose your shirt, then both options are foolish.

08-21-2005, 10:46 PM
Only do both if you are very very sure that the raw land will earn more over your investment time period of whatever, 10-20-30 years, than your 401K investment.

If you are not sure, why not diversify, and have some money in stocks in the 401K, leave it where it is, and have some money in the land.

Right now, the money locked up as equity in your home is the least effective. You don't need to leave the money there in order to profit from additional equity gains in your home. Does that make sense?

If the bank refuses to loan you any money unless you put a 10% downpayment on the home, then that downpayment is legally and financially necessary for you to own the home and profit from future gains in price and equity.

But any equity gain above and beyond the initial downpayment is deadmoney. It is not necessary to leave it there to control or own the home. It reduces your leverage and reduces your risk, by lowering your payment and lowering your risk of default on the mortgage.

But if you can SAFELY tap that equity, and if you can SAFELY earn more than a 2% tax-deferred return, then go for it.

08-21-2005, 11:43 PM
Two issues.
Is now the best time to buy the lot? Is it possible you might get a better deal in a year or two, if real estate prices are inflated now where you live, and will decline?

Buying raw land can be costly because you may be paying taxes on it, with no rental income to offset those costs.

But if you want to build your dream home there, I guess it is worth the cost and the risk.

Also, stock market returns, over long periods of 16-20 years tend to be superior. But for intermediate and shorter periods, returns can be downright bad. (Stocks for the Long Run, Siegel)

So it's not clear that my assumption is correct that keeping your 401 K money in stocks is a good thing.

But having said that, I still think the best move is to borrow against the equity in your home, rather than drain your 401K.

08-22-2005, 12:10 AM
I always wondered the what was best, listing all those reasons, the home equity way does sound like the better route in the long run.