If you’d like to add a master suite, an extra bedroom or a new playroom to your home, coming up with the money to pay for an addition can be a challenge. You could take out a second mortgage or look for other financing, but some people turn to another source of cash, their 401(k). Some plans allow you to borrow money for the short term and pay the funds back, with interest. Since you’re essentially paying interest to yourself, this can seem like a good deal, but consider all the pros and cons of this plan before you make a move.
Not all 401(k) plans allow you to borrow money, so check with your plan administrator to determine if you can use the funds to finance your home addition. To borrow from your 401(k) you must still be employed at the company where you have your 401(k), and you must repay the money through payroll withdrawals. If you fail to repay the loan within the required time limits, you’ll owe penalties and interest on the amount you withdraw.
Amount You May Borrow
You may only borrow up to 50 percent of the value of your 401(k), up to a maximum of $50,000. If your home addition is going to cost more than this amount, you’ll need to look elsewhere for financing. If you’ve already borrowed money from your 401(k) before, and if any of that amount was outstanding in the year previous to your new borrowing request, the amount you can borrow will be reduced by the amount of that first loan. For instance, if your 401(k) has a value of $100,000, you borrowed $10,000 last year, and you finished paying off that loan three months ago, you’d be able to borrow only $40,000 because you didn’t pay off the last loan more than a year ago.
You must pay back any loan you make from your 401(k) within five years, and you have to make a serious of even payments, at least every quarter. The payments will include a principal amount and interest at a rate equal to 1 or 2 percentage points above the prime rate. The money to make the payments will be deducted from your paycheck, so your income must be sufficient to pay your other bills even if you’re bringing home a smaller paycheck. If you quit your job or are laid off, you’re required to repay the loan in full within 60 days, so you’ll need a backup plan for repayment in that event. While you’re repaying your loan, some plans don’t allow you to make additional contributions. You’ll lose the tax credit for contributing to your retirement account, and the balance of the account will grow more slowly.
When you’re adding on to a home, the home itself is one source of money to finance the addition. If you’ve built up equity in your home, you may qualify for a home equity loan. These loans often have lower interest rates than you’d pay on a loan from your 401(k), you can repay the loan over a longer period of time if you need to, and you don’t have to worry about owing the balance of the loan suddenly if you lose your job. The interest you pay on a home equity loan is tax deductible if you itemize your taxes; interest you pay on the 401(k) loan is not deductible.
Cynthia Myers is the author of numerous novels and her nonfiction work has appeared in publications ranging from "Historic Traveler" to "Texas Highways" to "Medical Practice Management." She has a degree in economics from Sam Houston State University.