There's a reason consumers are told to be careful when borrowing via a home equity line of credit, or HELOC. Unlike personal loans, which come with fixed interest rates, HELOC interest is often variable. This means your HELOC payments could rise over time, costing you more money and making your debt harder to keep up with.
If you owe money on a HELOC, you may be thinking of tapping your nest egg to pay it off. But doing so could be a big mistake for multiple reasons.
You don't want to face costly penalties
The IRS gives you a tax break on the money that goes into a traditional IRA or 401(k) plan. And so if you touch that money ahead of retirement, you'll be penalized for taking a withdrawal.
A 10% early withdrawal penalty will come into play if you remove funds from your IRA or 401(k) prior to age 59 1/2. And while there are some exceptions, such as taking a limited IRA withdrawal to purchase a first-time home, if you remove money from your retirement account to pay off a HELOC, you'll lose 10% of your withdrawal. You'll also be taxed on the money you remove.
You don't want to end up short on retirement income
Another big reason not to raid your retirement plan to pay off a HELOC? You'll risk ending up short on income during your senior years.
Remember, when you take an early IRA or 401(k) withdrawal, you lose out on the opportunity to grow your money by investing it. So let's say you withdraw $15,000 today to pay off your HELOC, and your retirement plan is invested heavily in stocks.
Over the past 50 years, the stock market has delivered an average annual 10% return, as measured by the S&P 500 index. If that's the return you're able to snag in your retirement plan, and you take out $15,000 when you're 20 years away from ending your career, you'll actually cost yourself about $100,000 in savings. That's not exactly a negligible sum.
A better way to pay off your HELOC
You may be tempted to raid your retirement savings to pay off a HELOC when that money is sitting there in your name. But a better bet is to reduce your spending and pick up a side job so you're able to pump more money into your HELOC and get it paid off ahead of schedule. The sooner you pay off your HELOC, the less interest you'll end up paying on that debt.
You can also look at taking out a personal loan and using its proceeds to pay your HELOC off. In doing so, you will be swapping one type of debt for another.
But with a personal loan, you'll at least get the benefit of predictable monthly payments because your interest rate won't rise. So it may be a route worth considering, especially if you happen to be a borrower with strong credit. The higher your credit score, the more favorable a rate you're likely to qualify for on a personal loan.
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