Many families have the bulk of their net worth tied up in home equity. As a result, they often seek to access that equity to fund home improvements, vacations, debt retirement, taxes, or other expenses.
Your home equity is the excess of its current market value over any associated debt. If your home is worth $375,000, and the balance on your mortgage(s) is $230,000, your home equity is $145,000 (i.e., $375,000 – $230,000). Besides simply selling your home, there are three ways to tap into your home equity: cash-out refinance, second mortgage, or home equity line of credit.
A cash-out refinance involves obtaining a new mortgage that exceeds the value of your existing mortgage, and pocketing the difference after paying closing costs. In the above example, you could obtain a new mortgage for $340,000. After paying $10,000 in closing costs and $230,000 for the existing mortgage, the remaining $100,000 is deposited into your checking account.
A second mortgage, also known as a home equity loan, involves taking out an additional mortgage on your home. This is installment debt that is paid back on a set schedule over time. In the above example, you could borrow an additional $110,000 with a 15-year repayment schedule. You would have two loans against the house: the $230,000 primary mortgage and a $110,000 secondary mortgage.
What is a HELOC?
HELOC is an acronym for home equity line of credit. Unlike an installment loan, where you borrow a fixed amount that is repaid according to a predetermined schedule, a line of credit is functionally like a credit card, with the caveat that your home equity is pledged as collateral.
There are typically transaction costs involved with opening and using a HELOC.
Because you can borrow against your line of credit up to its limit, pay it off in whole or in part, and borrow and pay off again, it is a type of revolving credit.
What are the tax implications of borrowing against your home equity?
Not all home-related debt is the same, so it is not surprising that the tax implications of the various types also differ. Many folks believe that all home mortgage interest is tax-deductible, but that is not the case. (The principal portion of payments is never deductible.)
For your mortgage interest to be deductible—assuming you even itemize deductions—your loan must be “home acquisition debt” of $750,000 or less ($375,000 if married filing separately). Home acquisition debt means you used the loan proceeds to “buy, build, or substantially improve” your home. This is where folks usually get off track: A second mortgage or HELOC to pay off credit card debt or education expenses will not qualify.
The loan can be as high as $1 million ($500,000 if married filing separately) if you took out your mortgage between October 14, 1987, and December 15, 2017.
The monetary limits apply to the combined mortgages on your main home and second home.
The monetary limits apply to the mortgage loan balance, not to the home purchase price. If you purchase a home for $900,000 with a 20% down payment, and finance the remaining $720,000 cost, your mortgage loan interest will be fully deductible.
There is no monetary cap, and no “home acquisition debt” requirement, regarding mortgages taken out on or before October 13, 1987. Very few of these remain.
Refinancing your mortgage restarts the clock because it involves taking out a new loan. A refinance of home acquisition debt also counts as home acquisition debt, but only up to the balance of the previous mortgage. As a result, only a portion of the interest on a cash-out refinance will be deductible (unless all the cash proceeds were used for home improvement). In the cash-out refinance example above—taking out a new loan of $340,000 to replace a $230,000 mortgage, and receiving $100,000 in cash after paying $10,000 in closing costs—only 67.6% (i.e., $230,000 ÷ $340,000) of the mortgage interest would be deductible.
What are good uses of a HELOC?
In short, a HELOC is a great tool to have available if you need cash, and repayment of the HELOC is included in a well-reasoned personal budget.
The best use of a home equity loan is for debt consolidation purposes when all other debt is at higher interest rates. Paying 7% on a HELOC is much better than paying an average of 21% on your credit cards. With a lower interest rate, you can pay off the debt much quicker with the same total monthly payment. Debt consolidation also simplifies your life because you only have one payment instead of several. The trick here is to not incur any additional debt, and to retire your HELOC debt as quickly as possible. Remember, though, that the interest would not be deductible, even if your total mortgage loan debt is below the monetary cap.
A HELOC can also be a good way to finance a home improvement that is truly necessary and cannot be delayed, such as paying for repairs from storm damage while you file an insurance claim. Under this scenario, you have a planned timeline to repay the money borrowed using the HELOC (i.e., when the insurance money arrives in your bank account).
In a worst-case scenario, you could also tap a HELOC during a prolonged period of unemployment if your emergency fund dries up.
What are bad uses of a HELOC?
On the other hand, do not use a HELOC where you should be saving up and paying cash. Examples include unnecessary home improvements (like adding a sunroom or pool), vehicles, or vacations. For those, simply open a dedicated high-yield savings account for that purpose and deposit a predetermined amount in that account each month, ideally by automated electronic transfer.
Another poor use of a HELOC is to pay your day-to-day expenses. If your expenses exceed your income, then you need to increase your income, decrease your expenses, or a little of both; using debt to fund your basic lifestyle is not sustainable.
Finally, do not use a HELOC to take advantage of a tax deduction. You probably will not be able to deduct the interest anyway. Even if you are able to deduct the interest, it is better to have neither the interest expense nor the interest deduction than both the expense and the deduction. After all, a deduction is worth only a percentage (your marginal tax rate!) of your expense.
What if I am not sure if a HELOC is right for me?
A HELOC can be a powerful financial tool, but it can also be misused and put your home at risk, so be careful. If you need assistance in deciding whether a HELOC is right for you, reach out to us for help!
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