A home equity loan can be a good source of cash for an emergency line of credit, or to pay for college, a renovation or some other one-time expense.
Interest rates on home equity loans are lower than credit card rates. To make it even better, many borrowers can deduct the interest payments on their federal tax returns, regardless of how the money is used.
But the rules on deductions can be tricky, and it’s worth boning up before making the tax deduction a factor when deciding whether to take out one of these loans.
The BankingMyWay.com survey lists the average rate on a seven-year home-equity installment loan at 8.66 percent. You could easily pay twice that for a credit card. An installment loan charges the same rate for the life of the loan, while a line of credit has a variable rate that typically changes every month.
With the tax deduction taken into account, a borrower in the 25 percent tax bracket would, in effect, pay only 6.5 percent. That’s figured by subtracting the tax rate, 0.25, from 1 and multiplying the loan rate by the result: 1 - 0.25 = 0.75, and 0.75 x 8.66 = 6.495. Use the Mortgage Tax Saving calculator to pinpoint your potential savings.
This type of calculation generally uses the “marginal tax rate,” which is the rate that applies to the last dollar you earn, since the first dollar is not taxed and other portions of income are taxed at lower rates. According to the IRS tables, for 2008, used on the return due this spring, a married couple with a $100,000 income would be in the 25 percent bracket, while a single person with that income would pay 28 percent.
Some homeowners figure they can maximize their tax deductions by taking out large mortgages or home equity loans, or both. While this would indeed reduce your tax bill, it does not make sense to spend a dollar on interest just to save 25 cents on taxes.
But if you really need a loan, taping home equity can be a good choice, so long as you remember that the lender can take your home if you fall behind in payments.
To qualify for an interest-rate deduction, you need to satisfy a number of criteria spelled out on page 9 of IRS Publication 936.
No more than $100,000 in home equity debt can qualify for a deduction. And the limit may be even lower if you still have an ordinary mortgage on the property.
The IRS gives an example of a home currently worth $110,000 with a $95,000 balance on the original mortgage. The deduction would be limited to interest on no more than $15,000 of home equity debt, or the home’s fair market value minus the mortgage balance.
As a practical matter, this ceiling probably won’t hurt you because lenders have tightened loan limits to be sure there is enough home equity to secure the loan. The homeowner in the example probably couldn’t borrow more than $15,000.
If a lender would permit you to borrow above the limit described above, you might actually be able to deduct all of the interest if the money were used for an investment, since investment loans are eligible for tax deductions.
Another limit is triggered if part of your home is not used for ordinary living -- if it were rented out, for example.
Finally, people with larger incomes could face additional limits. First, higher-income households are subject to a phase-out of itemized deductions, which includes home equity interest. Second, if you are subject to the alternative minimum tax, equity interest is deductible only if the money is used to improve the property, not if it’s used to buy a car or pay off credit card debt.
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