Is a 401(k) Loan or a HELOC a Better Choice in 2021?

Financial Wellness By Noah - June 7, 2021

As summer starts to heat up and some families are working to “return to normal,” for many of us, the pandemic is still ongoing.  Homeowners who are struggling to understand 401(k) withdrawal rules, recent changes to 401(k) borrowing and home equity lines of credit (HELOCs), and other financing options may have a harder time recovering from pandemic financial setbacks. 

Why are HELOCs so hard to get right now? Can I still withdraw from my 401(k) without penalty? We’re here to decipher changing rules and give you the info you should know before choosing a financing option.

401(k) Withdrawal Rules 2021

As a refresher, most 401(k)s allow you to borrow a lump sum from your retirement plan. It’s not strictly speaking a “loan” because you’re taking funds from your own account, rather than working with a lender. A 401(k) withdrawal doesn’t impact your DTI ratio. It does come with an amortized repayment schedule, including interest (which pays back into your retirement account, not to the IRS, and can help offset gains you missed out on during the term of the 401(k) loan). If you make all payments on time, the overall impact on your retirement savings can be fairly minimal. But if you don’t meet your payment schedule, the IRS treats the outstanding withdrawal as income, subject to income taxes and early withdrawal penalties.

Can I still withdraw from my 401(k) without penalty in 2021?

While in 2020, the CARES Act waived the usual penalty for an early 401(k) withdrawal, 2021 was the cutoff. This year, 401(k) withdrawal rules returned to normal. The latest stimulus bill also includes a provision for 401(k) withdrawals, but the penalty waiver only applies to people living in an area where a major disaster other than COVID has been declared.

So depending on your area, it may still be possible to withdraw without a penalty from the IRS in 2021, although experts warn that you may still miss out on significant gains from the stock market. Many people who withdraw from a retirement account — or even take a 401(k) loan — never fully repay the balance, which can hurt your future finances.

What Is a HELOC?

A home equity line of credit (HELOC) is a home equity financing product that gives homeowners access to a revolving line of credit against part of their home equity. For example, let’s say you have a $100,000 HELOC. That means you can borrow up to that loan amount (although you can also take out less), pay it off according to the monthly terms, and borrow again as long as your HELOC is in effect. In this way, a HELOC behaves somewhat like a credit card (although usually with a much higher limit). The flexibility of a HELOC – only taking out what you need, when you need it – makes this a popular option for financing home improvement projects, but does come with closing costs similar to other home financing options.

HELOCs are generally a variable-rate product when it comes to interest, and interest rates can range from 2.62% to 21%, based on your credit and other factors. This means that your monthly payments can fluctuate significantly if interest rates change. If you were counting on a low-interest payment and the interest rate doubles, triples, or more, you might find yourself with a monthly bill that’s tougher to pay than you planned.

How the Coronavirus Pandemic Affects HELOCS

If you’ve looked into applying for a HELOC, you may have noticed that it’s harder than usual to access this type of home equity financing. Many banks and lenders took an economic hit due to the pandemic and, like households, often chose to cut expenses where they could. Chase, Wells Fargo, and Citi are among the banks that have stopped accepting HELOC applications altogether due to the pandemic. Other banks raised minimum credit score requirements, so if your score is under 720, it may be harder to get approved.

In most cases, if you already have a HELOC, you should be able to continue using it normally. But this isn’t a guarantee. Lenders can freeze or reduce the limit of your HELOC under certain circumstances, which can impact your ability to rely on these funds to fill financial gaps. Here are some of the main reasons why banks freeze HELOCS and the likelihood of this happening to you.

The value of your home value drops

HELOCs are based on your home equity, which takes appraised value into account. If the appraised value plummets, so does your equity, and lenders may reset your withdrawal limit accordingly. The national real estate market has been hot in 2021, so this outcome seems less likely for many borrowers.

You can’t make loan payments

If the lender has “reasonable belief” that you won’t be able to keep up with your repayment terms, that can be cause to freeze your HELOC. A change in marital status (read: pandemic divorce) or job loss could count as causes for this reasonable belief. Likelihood will vary, but you probably have a strong sense for whether your job security and marriage are likely to be a warning flag to lenders.

Your credit suffers

If you missed monthly payments, had a debt go to collections, or went through other situations that hurt your credit score, a lender may get concerned that you’ll default on paying your HELOC funds as well.

There’s been signs of a “K-shaped” pandemic recovery, with an almost even split between those who came through the pandemic with steady or even improved finances, and those who suffered a major economic toll. Some Americans have been paying off credit card debt at the fastest rates in decades. But about half of Americans took on more debt to make it through 2020. Your credit may be one of the strongest signs right now of whether you’ll be able to keep using a HELOC as normal.

It’s difficult to say for sure when banks will resume processing HELOC applications or return credit checks and other requirements to pre-pandemic standards. Until then, if you’re hoping to access needed funds and want to leave your 401(k) alone, you may need to explore alternate home equity products on the market.

How Noah Works With Homeowners

Like a 401(k) “loan” and a HELOC, Noah’s Home Value Investment isn’t a traditional loan, either. It won’t show up on your credit report or add to your DTI.

One advantage of considering a Home Value Investment, especially in these times, is that Noah may take a more flexible look at your current finances. Noah considers homeowners with a maximum 60% debt-to-income ratio and minimum 580 credit score, which may open doors for homeowners who wouldn’t get approved for a HELOC. Homeowners can also avoid worrying about missing monthly payments, sacrificing future retirement funds, or incurring large penalties as they might with a 401(k) loan.

Choosing what’s right for you

While we’ve all experienced the pandemic, your family’s financial needs are distinct to you. Whether you’re still weathering effects or beginning the road toward a “new normal,” consider your unique financial situation and multiple financing options to decide the best tools to help you on your way.