Tax Advantages of a Home Equity Loan
Find out the tax advantages of a home equity loan versus credit card and other debt.
If you own a home and have equity--that is, you owe less than the home is worth--you have the option of taking out a home equity loan. This is simply a loan secured by the equity in your home. You can take out a traditional second mortgage loan in a fixed amount, or obtain a home equity line of credit secured by your home with a set maximum limit. You can use the proceeds of a home equity loan for any purpose.
Home equity loans have a couple of advantages. First, the interest rate is usually much lower than the rates charged on credit cards, car loans, or other consumer loans. Second, the interest you pay on a home equity loan can be tax deductible as an itemized deduction on IRS Form 1040, Schedule A. This is not the case with loans other than home loans-- for example, you can't deduct the interest you pay on your credit card bill each month, or on a car loan (unless you use the car for business).
The combination of a lower interest rate plus tax deductibility is unbeatable. Because of the lower interest rate on the home equity loan, you'll have a lower monthly bill if you take out such a loan and use the proceeds to pay off your credit card debt or high-interest consumer loans--a process called loan consolidation. In addition, you'll also obtain a valuable tax deduction that will lower your tax bill come tax time.
Example: Bill owes $50,000 on his credit cards. His annual interest payments on this debt are $5,000. He takes out a $50,000 home equity loan and uses it to pay off his credit cards. The annual interest he pays on the home equity loan is only $2,000. In addition, he deducts the interest as an itemized deduction, saving him $500 in income tax.
It's important to understand, however, that your ability to deduct the interest you pay on a home equity loan is not unlimited. Only the interest on a home equity loan on a main or second home of up to $100,000 is deductible. Interest on home acquisition loans of up to $1 million is likewise deductible. A home acquisition loan is a loan used to buy, build, or substantially improve a home.
Thus, you can deduct the interest on a total of $1.1 million in home loan loans each year. If you have a second home as well as a main home, this limit applies to the total debt for both homes. If your loans exceed the limit, the additional interest is not deductible.
Finally, keep in mind that a home equity loan is secured by your home. This means that if you fail to make your payments, the lender can foreclose on your home--a relatively easy and simple process in most states. Losing your home is usually not a big risk when you fall behind on credit card payments, car loans, or other unsecured loans. A credit card company or other unsecured lender can obtain a court judgment against you if you fail to pay. However, it's difficult and expensive to sell someone's home to satisfy such a judgment; and, in practice, it's rarely done.
If you're interested in obtaining a home equity loan, it pays to shop around because the rates and fees lenders charge can vary widely.