Friday, July 31, 2015

Ask Carrie: What’s the best way to pay for a home renovation?

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That home renovation is going to cost you – what´s the best way to pay?
That home renovation is going to cost you – what's the best way to pay?

Dear Carrie,

We’re doing a major home renovation and are weighing the best way to pay for it. What’s better, taking a 401(k) loan or borrowing from a HELOC? Another option is to sell some stocks. What do you think? 

—A Reader

Dear Reader,

There’s some merit to each of the possibilities you mention. A lot depends on your personal financial situation, but I do have thoughts on all three.

A 401(k) loan—my least favorite

On the surface, borrowing from a 401(k) makes sense. It’s your money, interest rates are fairly low, and you pay the interest to yourself. But, to me, it should be last on your list because not only are you depleting your retirement savings, you’re also paying more in taxes.

Let’s say you borrow $20,000. Right away that money is no longer working for you tax-deferred. Plus, you’re borrowing money you put in pre-tax but, even though you’re paying it back with interest to yourself, your payments are made with after-tax dollars. Then you pay ordinary income taxes on your withdrawals at retirement time, so you’re actually taxed twice on that repayment.

Finally, a 401(k) loan generally has a five-year repayment schedule—unless you lose or change your job. Then you usually have to repay it within 90 days or it’s treated like a distribution, subject to income taxes and a 10% penalty if you’re under 59½. That can be a big financial hit.

The pluses of a HELOC

I’m more in favor of a home equity line of credit, as long as you have enough equity in your home and you’re not overextended debt-wise. There are a couple of reasons why.

While interest rates vary, and may be slightly higher than on a 401(k) loan, you can deduct the interest expense on up to $100,000 ($50,000 for married filing separately) of home equity debt secured by your home, whether it’s a regular loan or a revolving line of credit. So you have to factor in tax deductibility when comparing interest rates. For instance, if you’re in the 25% tax bracket with a fully tax deductible HELOC at 5% interest, you’re really only paying about 3.75%.

Plus, a HELOC is usually taken out for a longer time period, giving you greater repayment flexibility.

Selling stock carefully

Selling stock may also be a good option—as long as you choose carefully. First, look at quality. If you wouldn’t buy the investment today, it’s a good sell candidate. Next, look at your asset allocation. If the rise in the market has increased the stock portion of your portfolio beyond your comfort level, you could sell stocks to bring it back in line. Also, are you overflowing with one category of stock or the stock of one company? This could be a good time to pare back.

Finally, don’t forget taxes. Look ahead to your annual tax bill, balancing gains with losses. And remember that a gain on an investment you’ve owned for less than a year is taxed at your ordinary income tax rate, not the lower capital gains rate.

How about all three?

Nothing says you have to use a single approach. A combination might be the best way to balance risk and debt and protect your retirement.

First, look at your overall debt to decide how much to borrow from a HELOC (as a general rule, no more than 28% of your pretax income should go toward home debt; 36% toward all debt). Then review your portfolio to see if selling certain stocks or bonds makes sense. Last, if it’s absolutely necessary, consider a 401(k) loan, but borrow as little as possible and pay it off as quickly as you can.

This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. COPYRIGHT 2014 CHARLES SCHWAB & CO., INC. MEMBER SIPC. (0314-2028)

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Carrie Schwab-Pomerantz
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