Home Equity Loan vs. IRA Withdrawal: Which Option Is Better?

Borrowing money or tapping into savings can be a tough decision, especially when it involves major assets like home equity or retirement funds. Each option carries financial consequences that affect taxes, credit, repayment obligations, and long-term stability. Understanding these factors is essential before making a choice.

Collateral Requirements

A home equity loan requires using your property as collateral. Lenders place a lien on the home, meaning failure to make payments could result in foreclosure. The amount available to borrow depends on equity, calculated by subtracting the mortgage balance from the market value. Most lenders allow borrowing up to 80% to 85% of equity, though creditworthiness and lender policies influence the final amount.

Because the loan is secured by the home, interest rates are generally lower than unsecured loans. Fixed-rate home equity loans offer stable monthly payments, while home equity lines of credit (HELOCs) have variable rates that fluctuate with market conditions. Missing payments can lead to foreclosure, so borrowers should assess their ability to repay before proceeding.

Withdrawing from an IRA does not require collateral, eliminating the risk of losing property. However, taking money from retirement savings reduces future financial security. Unlike a loan, there is no repayment obligation, but the loss of investment growth can have long-term consequences.

Early IRA Distribution Rules

Withdrawing from an IRA before age 59½ usually incurs a 10% early withdrawal penalty in addition to regular income taxes. Traditional IRA withdrawals are taxed as ordinary income, while Roth IRA contributions can be withdrawn tax-free. However, earnings in a Roth IRA are subject to taxes and penalties unless certain conditions are met.

Some exceptions allow penalty-free withdrawals, though taxes may still apply. Up to $10,000 can be withdrawn for a first-time home purchase, and funds can also be used for qualified higher education expenses, unreimbursed medical costs exceeding 7.5% of adjusted gross income, disability, and certain military service-related needs.

Another option is substantially equal periodic payments (SEPPs), which allow penalty-free withdrawals based on life expectancy. These payments must continue for at least five years or until age 59½, whichever is longer. If the schedule is not maintained, retroactive penalties apply to all prior distributions.

Tax Withholding Considerations

Traditional IRA withdrawals are subject to automatic 10% federal tax withholding unless the account holder opts out or selects a different percentage. This withholding is a prepayment of taxes owed, not an additional tax. Large withdrawals can push taxpayers into a higher bracket, increasing overall tax liability. Some states also require withholding on early distributions.

For Roth IRAs, tax withholding depends on whether the withdrawal includes earnings. Contributions can be withdrawn tax-free at any time, but earnings withdrawn before meeting the five-year rule or other qualifying conditions may trigger taxes and penalties.

Home equity loans do not involve tax withholding since they are not considered income. However, interest paid on the loan may be deductible if the funds are used to buy, build, or improve the home securing the loan. The IRS limits mortgage interest deductions to a total debt of $750,000 for joint filers and $375,000 for single filers. If the loan is used for other purposes, such as debt consolidation or medical expenses, the interest is not deductible.

Credit Score Factors

Applying for a home equity loan results in a hard credit inquiry, which may temporarily lower a credit score. Once approved, the new account increases available credit, which can improve the credit utilization ratio. However, taking on new debt affects the debt-to-income (DTI) ratio, which lenders consider when evaluating future credit applications.

Payment history is the most significant factor in credit scores. Making on-time payments strengthens credit, while missed payments can cause long-term damage. A delinquency of 30 days or more remains on a credit report for up to seven years. Since home equity loans are installment debt rather than revolving credit, they contribute to credit mix, which accounts for a smaller portion of a FICO score.

IRA withdrawals do not affect credit scores because they are not loans. There are no credit inquiries, new debt, or repayment obligations. However, using IRA funds to cover expenses instead of relying on credit can help avoid missed payments on existing obligations, indirectly preserving credit health.

Loan Repayment Obligations and Account Reduction

Home equity loans require structured monthly payments over a fixed term, typically five to 30 years. Payments include both principal and interest, and failure to pay can result in late fees, credit damage, and foreclosure. Unlike credit cards, home equity loans do not allow flexible repayment amounts, making it important to ensure affordability before borrowing.

IRA withdrawals do not require repayment, but they permanently reduce retirement savings. Removing funds eliminates potential tax-deferred or tax-free investment growth. For example, withdrawing $50,000 from an IRA that would have earned an average annual return of 7% could result in a loss of over $190,000 in potential growth over 20 years. Additionally, withdrawing from a traditional IRA increases taxable income, which may push the account holder into a higher tax bracket.

Each option has financial trade-offs, and the best choice depends on individual circumstances, long-term goals, and repayment ability.