During difficult times, you may find that borrowing money is unavoidable. But did you know that some methods of borrowing are better than others?
While payday loans are arguably the worst way to borrow money, home equity loans and lines of credit are two of the better options. From low interest rates to tax deductions, there are several advantages to taking out a home equity loan that you should know about.
A home equity loan, often called a second mortgage, is a loan where you use the equity of your home as collateral, with the amount of the loan determined by your credit score, the equity you have in your home, and your debt-to-income ratio. People will often take out a home equity loan in order to finance large purchases or expenses, such as home remodels, medical bills, or college debt.
The difference between a home equity loan and a home equity line of credit (HELOC) is that a home equity loan functions as a second mortgage and is a lump-sum loan with a fixed interest rate over a set period of time. A HELOC is a line of revolving credit that can be drawn from as needed for an initial period with fluctuating interest rates, after which the line of credit is typically converted to a fixed-rate loan.
The other common way to access your home equity is through a cash-out refinance, which is when you refinance your current mortgage and take out a bigger one. A cash-out refinance makes sense when today’s rates are lower than your existing mortgage’s rate, as they certainly have been this spring.
A home equity loan is a good option for you if the value of your home is greater than what you owe on the mortgage (also known as equity). If you are in this position and you need to borrow money to cover an unexpected expense, such as a home repair, a home equity loan might be your best bet. Here are a couple of reasons why home equity loans and lines of credit are attractive borrowing options:
Compared with many other types of borrowing—such as a credit card cash advance or a payday loan—a HELOC has relatively reasonable terms.
While the interest rate of a credit card cash advance can be up to 25 percent, the average rate of a home equity loan is about 5.6 percent. HELOC rates are closer to 6 percent, but in the wake of the Fed’s move to dramatically lower rates, borrowers will likely benefit from smaller monthly payments over the coming months.
If you find that you can’t deduct all of the interest on a home equity loan (as we’ll discuss next), HELOCs may be a smart alternative since their interest rates are significantly lower than rates on consumer debt.
Another major benefit of home equity loans is that at least part of the interest you pay on them could be tax deductible—although you should be aware that the Tax Cuts and Jobs Act of 2017 placed some restrictions on mortgage interest rate deductions.
When the details of the Jobs Act were released, many believed it spelled the end of HELOC tax advantages, such as interest deductions. But in 2018, the IRS issued an advisory statement stating that interest paid on home equity loans and lines of credit remained tax deductible in many cases, as long as the loan was used to “buy, build or substantially improve” the home that secured the loan.
The takeaway is that there are still tax advantages associated with home equity loans and lines of credit—just be sure you understand how the changes affect you.
Here are the three primary things you should know about HELOC tax deductions:
The main caveat to be aware of is that interest from home equity loans and HELOCs taken out on December 15, 2017, or later can no longer be deducted when the loan or line of credit is used to pay for personal living expenses, including:
However, if you used that money to, say, put an addition on your home, then the interest on that loan is tax deductible, as long as the total amount of both loans does not exceed $750,000.
For mortgages taken out prior to December 15, 2017, taxpayers can deduct mortgage interest on up to one million dollars of qualified residence loans, but for mortgages taken out after that date, the limit is $750,000 if you are single or married filing a joint return ($375,000 for married filing separately).
These limits are important to keep in mind because home equity loans and lines of credit count toward that total. For example, if you took out a $500,000 mortgage last year, you can deduct the interest on a HELOC of up to $250,000 because the two combined equal the $750,000 limit. And as mentioned above, the HELOC must be used to improve the home if you want that deduction.
Considering the restrictions placed on home equity loan and line of credit interest deductions, it’s particularly important to keep track of any home improvement expenses. Save any receipts or documents that show the money from a home equity loan or line of credit went toward improving the home that secured the loan. If you have any concerns about the best way to track your expenses, talk with your tax advisor or accountant.
In order to take advantage of this tax deduction, you must file a Form 1040, itemize your deductions, and have a home equity loan or HELOC on a qualified home in which you have an ownership interest.
Note that itemizing your deductions only makes sense if your deductible expenses add up to more than the standard deduction, which for the 2019 tax year was set at the following amounts:
In addition to filling out Form 1040, you should also make sure you receive IRS Form 1098 (Mortgage Interest Statement) from your lender. This form shows the interest you paid on your primary mortgage, home equity loan, or HELOC in the previous year, and is required to deduct the interest on your home equity loan or line of credit.
If you still have questions about whether your home equity loan interest is tax deductible or if you’re considering taking out a second mortgage, contact us today to schedule a conversation.