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Dr. Don Taylor, CFA, Bankrate.com advice columnist401(k) loan for home improvements

Dear Dr. Don,
I'm considering taking a loan from my 401(k) at 4 percent interest. The investment portfolio only earned about 3 percent over the past 12 months. I will spend the money on physical improvements to my home, which I can conservatively expect to increase in value by about 8 percent due to the improvements.

I live in an unusual historic neighborhood where home improvements are highly beneficial and are consistently rewarded. Is this a good use of retirement funds that show weak performance? -- Matt Mortgage

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Dear Matt,
If your retirement funds aren't performing well, that's good reason to reassess how they're invested but not a particularly good reason to borrow against them. Loans against your 401(k) plan should be an absolute last resort in the case of a financial emergency, not a funding source for home improvements.

The interest rate on a HELOC (home equity line of credit) should be right on top of the rate you'd pay on a 401(k) loan, plus the HELOC interest expense may generate a tax deduction, lowering the effective rate on that loan to around 3 percent.

Even if your home's value is appreciating by 8 percent annually, most home improvements don't recoup the initial investment, much less track the local housing market. Remodelingonline.com has an annual Cost vs. Value report that tracks how well remodeling projects recoup the owner's investment.

A 401(k) loan typically comes due immediately if you leave your current employer. If you can't repay, the loan is treated as an early distribution and you'll owe income taxes and a penalty tax on the loan balance.

With some plans you can't contribute additional funds until you pay off the loan. If it takes you five years to pay off the loan, you've put your retirement savings on hold for that period of time. Loan payments are made with after-tax dollars, so you're replacing tax-deferred funds with after-tax dollars. If you can't contribute to the plan while you have a loan outstanding, you're also forgoing any company match.

To ask a question of Dr. Don, go to the "Ask the Experts" page, and select one of these topics: "Financing a home," "Saving & investing" or "money."

Bankrate.com's corrections policy -- Posted: May 3, 2004
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