A 2nd Mortgage Versus a 401K Loan
Added: September 27, 2006
Which is better. Borrowing money against a 401K or getting a second mortgage on a home? The question of a 2nd mortgage versus a 401K loan is one that many people ask on a regular basis. To answer the question, let’s take a look at each method, and define it.
A mortgage is a loan against a piece of property, in this case a home. A second mortgage is a loan using a portion of the equity in a home as collateral. This makes the lender in essence second in line to collect funds in the home owner should default. So if a home is worth $50,000 and has a first mortgage of $30,000 and a second mortgage of $20,000, and the home defaults, then when the home is sold the first mortgage holder will be paid first, and then remaining funds will be used to pay off the second mortgage holder. If the home sells for full value both come out ok. But if the home sells for less the holder of the second mortgage is more at risk. If for instance the home only sold for $40,000 then the holder of the second mortgage would only receive $10,000. This makes the position of the holder of the second mortgage in some ways a bit more risky than the holder of the first mortgage. For this reason sometimes a second mortgage will charge a slightly higher rate of interest.
A 401K is a retirement plan managed by an employer and subject to strict federal government guidelines. Funds placed in a 401K account are tax deferred, meaning that no taxes will be paid on the funds or on the interest or dividends the funds earn until they are withdrawn, as which time the account owner will probably be in a lower tax bracket and able to control his taxation rate to his own benefit. Also employers usually match a percentage of the funds that an employee deposits in a 401K. The 401K is very similar to the Simple IRA and SEP or simplified employee pension plans used by very small businesses but are designed for larger companies with more employees. They also bear a strong resemblance to the IRA or individual retirement account that an individual can have.
If a person owns a home and is in need of funds for some purpose and has both a 401K account and equity in the home then the question of a 2nd mortgage versus a 401K loan often comes up. Which is better probably is best determined by the individual in concurrent with consultation with a financial planner who can show the home owner the benefits and disadvantages of each.
A lender will want collateral of some sort on a large loan. That goes without saying. If the person getting the loan defaults then the lender must have some way of recovering the investment. Many lenders however, if a person has only a small amount of equity in a home, may be much more willing to talk about using the funds in a 401K account as collateral. This can create more reasonable terms for a loan and make it easier for a person to get. At times being able to get a loan quickly and without hassle can be more important than getting the lowest rate of interest. It depends on the individual person’s needs and financial situation of course.
Other people prefer getting a second mortgage because the interest paid on a mortgage is a valid tax deduction. However, a tax deduction is different from a tax credit, and while it is an attractive benefit of a mortgage type loan, it may not be of sufficient benefit to justify going that route.
The best thing for a person considering choosing between the two types of loans to do is to sit down with a lender or financial professional, and perhaps a tax preparation specialist and put the pencil and calculator to work, figuring out just how a person will come out financially both ways. Then when looking at tax savings, interest rates, loan closing fees for each type of loan, penalties for early payment and late payment, and other factors, then determine which is best for the individual situation involved. A person may just be surprised and find that the 2nd mortgage versus 40-1K loan question has a very different answer for each person who looks at the question.
Of course some people go so far as to take classes in financial management in order to make these decisions themselves or to simply increase their knowledge base in order to be able to discuss the question with more clarity when talking to experts in the field. Gaining knowledge in an area such as a 2nd mortgage versus a 401K loan, or any other financial area is never a bad thing, and often can be quite helpful to a consumer when considering the different financial options available. Determining if a 2nd mortgage versus a 401K loan is right for you is a very big decision and should not be undertaken lightly or without sufficient knowledge. The more education a person can get in this area the wiser the decision he or she eventually makes will be. There are many big and important financial decisions made in life. When to get married, when to have children, what type of job to take, what type of education to pursue, what home to buy, and what type of retirement plan to have. The question of a 2nd mortgage versus a 401K loan is one of those important financial questions in a person’s life and one that requires gaining as much information as possible in order to make a sound financial decision. Learn all you can, consult with several bankers, insurance executives and other people in the business of financial management and lending, and then make your decision well armed with all the facts you can muster. To make a good decision have all the information available that you can find.