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Home equity versus 403(b) loan

Dear Dr. Don,
Generally, is it better for tax purposes to borrow from a bank at 6.2 percent and get a tax deduction or borrow from my 403(b) at 4 percent with no interest tax deduction? I am referring to a $75,000 home equity loan.
-- Pat Payments

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Dear Pat,
Borrowing from your 403(b) is seldom the right move if you have other options available. You're paying the loan back with after-tax dollars, and the loan comes due immediately if you leave the employer. If you couldn't repay the loan at that time, the outstanding loan balance would be treated as a distribution and subject to income taxation and, depending on your age at the time, potentially subject to an additional 10-percent penalty tax.

The loan term is typically for five years or less and is usually limited to the lesser of half your account balance, or $50,000. Plan loans relating to the purchase of a principal residence may be for a longer term. You might also face limits on your ability to make additional contributions to the plan for a period of time. That becomes an even bigger deal if your employer matches all or part of your contributions and you lose the employer match for a period of time. Your employer's human resources department is the best source of information about the terms and conditions of a plan loan.

If you're in the 25-percent marginal tax bracket and can use the mortgage interest deduction when you file your income tax return, the effective rate on your mortgage debt is 4.65 percent. The effective rate is even less if you can also use the mortgage interest deduction on your state taxes. A CCH calculator will help you determine the effective interest rate on your home equity loan. Refer to the IRS 2005 Tax Rate Schedule for marginal federal income tax rates.

As you can see, there's a lot more behind this decision than just comparing effective interest rates. Your ability to afford repaying the loan off over five years with a plan loan versus 10 to 20 years with a home equity loan is another consideration in choosing between the two loans. Take a look at the big picture and make your best decision, but don't let the interest rate be your only decision variable.

Bankrate.com's corrections policy -- Posted: Dec. 9, 2005
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