How to Pay for that New Patio

As we progress through the dog days of summer, we may be spending more time in our backyards savoring what’s left of these warm evenings. As those of us in Northeastern Ohio know, these balmy sunsets will soon be replaced by gently falling leaves, then blowing snow.  As we kick back with friends and family (and maybe an adult beverage or two), occasionally the topic of home improvement projects comes up and this usually makes for interesting discussion as we paint the mental picture of our dream backyard or kitchen makeover.

As evidenced by the many home improvement shows on today, it’s clear there is no shortage of ideas and these projects are really limited by two things:  your imagination and your balance sheet.  So setting aside the landscape architecture questions (not my specialty), the remaining question is – how should a family pay for this? (this is my specialty)

Savings?  Credit Card?  Home Equity Line of Credit?  Home Equity Loan?  401(k) Loan? (There are other options such as cash value in permanent life insurance policies but I have to cut it off somewhere)

I think it’s best to analyze this within the context of an example.  Let’s say you and your spouse made the decision that you want to replace that cracked and tiny concrete slab in your back yard with a nice brick patio, complete with landscaping, elegant lighting and a fire-pit (which I would personally love).  Let’s say you completed your due diligence on contractors and determined this project will cost you $50,000 all-in.   Where will the funds come from?  The answer ranges from simple to complex so let’s review the options:

Savings:  This is a no brainer with one BIG caveat.  I say no brainer because, assuming you have the funds readily available, NOT paying interest on a loan is clearly the best approach.  However, the caveat is that I would not suggest this option unless you already have ample liquidity (like 6 – 12 months living expenses) in accessible cash and all your other savings goals like retirement and education savings are on or ahead of schedule.  If not, I think a loan should be considered.  But which type?

Credit Cards: Another no-brainer but not for the same reason.  $50,000 of credit card debt is a terrible idea as this is technically unsecured debt.  To a bank, this means higher risk, which means higher interest rates and higher payments.  In addition, the interest on this debt is not tax deductible so in my view, this is a bad idea from many angles.

Home Equity Line of Credit:  This is where things get interesting.  A home equity line of credit (or HELOC) is a line of credit backed by the value of your home.  So if you have sufficient equity in your home, you can establish a credit line to draw on whenever you desire (subject to the bank’s time and borrowing limitations).  The interest rates are much lower than credit cards AND interest expense is tax deductible (subject to some limitations).  But, there’s a twist: the rates are variable and while they’re currently attractive (as of today, between 3.25% to 4.00%) they could fluctuate- as will your payment.  The amount you can borrow is usually limited to some percentage of the equity in your home (usually up to 80%) so if you have less than 80% equity in your home, your borrowing power is greatly reduced in most cases.

Home Equity Loan:  This is also a loan backed by your home equity but instead of having access to a credit line where you borrow what you need (up to the limit), you get one lump sum.  You pay this back with fixed principle and interest payments and while rates are slightly higher (~4.2% – 5.4% today) than a HELOC, they’re also fixed so you have certainty on the cash needed for payments.    Much like the HELOC, the amount you can borrow is usually limited by the amount of equity in your home and importantly, the interest expense on these loans is also usually tax deductible.

401(k) Loan: This is where things get complicated.  An employee with a 401(k) can usually take out a loan on their vested 401(k) balance, subject to limitations.  These loan programs differ by employer but in most cases the loans work like this:

  • This is not a taxable distribution
  • The interest rate you pay is usually the prime rate + 1%.  So that would be about 4.25% today but can be variable
  • Your interest portion of your payment is really going back into your 401(k) account so it’s actually considered “borrowing from yourself” as you aren’t paying interest to a bank but back to your 401(k)
  • 401(k) loans usually need to be paid back over 5 years unless borrowing to buy a home, then it’s usually 10 years
  • If you lose your job (or decide to switch jobs) you typically have to payback loan within 60 days
  • 401(k) loan has borrowing limits. Typically, the employee can only borrow ½ vested value in the account or $50,000, whichever is less (so if you have $500,000 in your 401(k), ½ vested is $250,000 but you can only borrow $50,000)
  • 12 month restriction: if an employee already took a 401(k) loan within the past 12 months or has an outstanding loan, that loan amount must be subtracted from the amount that the employee would otherwise be able to take for a loan (the lesser of $50,000 or ½ of the vested account balance).

So bottom line:  assuming you don’t have $50,000 in cash lying around and assuming you’re smart enough not to run up your credit cards, I believe your choices come down to one of three options:  401(k) loan, HELOC or home equity loan.  My favorite?  The home equity loan and here’s why:

1)      With a 401(k) loan you are robbing yourself of future growth in your account.  You might counter with the fact that you’re not really paying interest but paying yourself back.  This is true but I spent way to long analyzing this situation and after running the numbers several ways, the bottom line is that the future compounding in the larger 401(k) account balance (assuming ~7% annual portfolio returns) along with the tax deductibility of the interest on the home equity loan means you usually come out slightly wealthier when utilizing a home equity loan.  This is primarily because the “payback” of the interest rate on 401(k) loan is usually lower than what you could earn on investments.  The risk of your “return” in the 401(k) loan payment is admittedly lower but that’s an argument for another time.

2)      With a home equity loan, you usually have a longer time period to amortize the loan.  With a 401(k) loan, the payback period is usually limited to 5 years, which could constrain cash flow.

3)      With a home equity loan your balance due is not tied to your employment status so if you want to switch jobs or if you lose your job, you won’t have to pay off the loan, which is typically the case with a 401(k) loan.

4)      With a home equity loan, your payments are fixed and your interest expense is deductible.  With a HELOC, the interest expense is also deductible but the payments are subject to the variances in market interest rates.

Putting this all together:  In my mind, the home equity loan is the best combination of flexibility, certainty and financial terms for a $50,000 patio project requiring a lump sum payment.

One final question to address:  What if you don’t have excess liquid savings, enough equity in your home or enough in your 401(k) to finance a $50,000 home improvement project?  What to do then?

This is a simple answer, but might be difficult from some folks to hear……..

The answer is: nothing – you can’t afford it yet.

So what do you think?  How have you paid for projects like a patio?  I’d love to hear your thoughts, comments, questions or criticisms.

4 Comments

  1. Very timely and thoughtful. Wait for an uptick in the market and sell stocks that have no dividends or less then 4 %. Thinking of adding on to my house and weighing options. Thanks for the thoughts, Tony.

    Reply

  2. This was an excellent analysis to compare all avaiable funding instruments when trying to make a decision on which one to use.

    Question: What if you borrow from your 401k that part that is in cash or low risk securities which typically pay lower returns?

    Thanks,

    Kevin

    Reply

    1. Thanks Kevin- great question.

      That certainly helps the equation as we compare the “average return” of your 401(k) payback vs. the tax-adjusted interest you pay. In fact, one could argue that you can re-allocate your 401(k) to 100% stocks and consider your 401(k) loan payback as the “bond” portion of your portfolio, returning the loan interest rate, say 4%, which isn’t a bad return. That can make some sense but a couple aspects that I don’t like.

      First, a 100% stock portfolio would theoretically be higher growth but of course, it would be higher risk too. So while the average return would be higher, we’re only talking a 5 year payback (on the home equity loan) so the 401(k) in stocks could be very volatile in that relatively short time period. That’s OK- you’d just have to acknowledge that and be able to endure the volatility, if it happens.

      Second, I’m big on flexibility and leaving your options open and when you take the 401(k) loan and sink it into a home improvement project, then you’re locked into your job or facing a payback of the loan. Of course, you could always take out the home equity loan, payback the 401(k) loan then switch jobs. But if you unexpectedly lose your job, you may have to pay back the loan within 60 days. And with no job, the bank will probably not be so quick to give you a home equity loan.

      Reply

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