Your home is an asset on your balance sheet, which can help boost your wealth. There’s only one problem. Real estate is an illiquid asset, meaning you can’t easily turn your home into cash. While selling is always an option, the process is usually slow, stressful, and comes with costs of its own. That doesn’t mean you can’t tap into your home as an asset, though. With a home equity loan, you can borrow against your property’s equity (or the amount the property is worth after accounting for what you still owe on your mortgage).
Home equity loans allow you to receive a lump sum of cash which you then repay via monthly payments over a certain term. A home equity line of credit, also known as a HELOC, allows you to leverage your equity, too. But in the case of a HELOC, you don’t get a lump sum of cash. You create a line of credit that you can use when you need. If your line of credit is worth $10,000, for example, you could use $1,000 any time and pay that balance back any time before the line of credit expired.
Both a home equity loan or a HELOC can serve as tools for homeowners to leverage when needing access to cash. But in either case, there’s a fee for tapping into your equity and that comes in the form of interest. The more you pay in interest, the more expensive a home equity loan or a HELOC can become.
The good news is that there are some tax benefits to borrowing on your home. The bad news is that some of these benefits are no longer as strong (or present at all) now that Congress passed a new tax law called the “Tax Cuts and Jobs Act” in December of 2017. While there are still some tax advantages left, using home equity could be even more expensive for homeowners than it once was. Keep reading to learn how a HELOC or home equity loan will impact your taxes and whether your loan interest will be deductible in 2018 and beyond.
Home Equity Loans, HELOCs, and Your Taxes
The IRS allows taxpayers to deduct home mortgage interest from their adjusted gross income when filing a tax return. The agency considers home mortgage interest as any interest you pay on a loan that’s secured by your home.
The interest you pay on a home equity loan or HELOC qualifies, too, because you use the equity in your home as collateral.
The caveat? You need to itemize your deductions to take advantage of this tax break and see some savings. Only about 30 percent of households itemized, according to the most recent IRS data from 2013.
That’s probably because it simply didn’t make sense for most people to do so, because the standard deduction is often larger than the itemized deductions average taxpayers qualify for.
If your overall itemized deductions (which include expenses like eligible medical expenses, charitable donations, and certain state and local taxes) don’t exceed your standard deduction amount, it doesn’t make sense to itemize. Not itemizing means that you don’t reap the tax benefits associated with borrowing against your home.
How the New Tax Law Impacts the Mortgage Interest Deduction
The standard deduction for the 2017 tax year for a married couple filing jointly was $12,700. If you paid $20,000 in mortgage interest on your first mortgage and you paid $5,000 in interest on a home equity loan, you could deduct $25,000 — almost double the standard deduction.
In this scenario, the impact of the home equity loan interest was to decrease your taxable income by $5,000. If your effective tax rate was 25 percent, for example, the tax savings that you could attribute to your home equity loan interest was $1,250 ($5,000 x 25%).
The new tax law increases the standard deduction for a married couple filing jointly to $24,000. This is effective starting in the 2018 tax year.
Continuing the example from above, if you pay the same amount of mortgage interest in 2018 as you did in years past, that means only $1,000 of your itemized deductions can be attributable to your home equity loan. Assuming the same effective tax rate, your tax savings resulting from your home equity loan is now just $250.
The new law also lowers how much mortgage interest you can deduct. In 2017, you could deduct mortgage interest on home mortgage indebtedness up to $1 million. That cap goes down to $750,000 in 2018.
If you have a HELOC or home equity loan, that might push you above the new $750,000 cap — meaning your interest might not be deductible at all.
Lastly, the new law says that from 2018 forward, interest on a HELOC or home equity loan cannot be deducted unless the money was used to buy, build or substantially improve your home. In other words, if you took out a home equity loan and used the money to pay off your credit card debt, you can not deduct the interest on that loan.
The Pros and Cons of a Home Equity Loan or HELOC?
In the past, you might have been more likely to see a tax break if you had a home equity loan or HELOC. Starting in 2018, it will be more difficult to leverage these loans and lines of credit for a tax advantage.
That doesn’t mean HELOCs and home equity loans are no longer useful. But it does mean there’s less of an argument for getting one simply because it might also help you reduce your tax burden.
These financing options still usually offer lower interest rates than personal loans, and cost a lot less to use than carrying balances on credit cards. You may also have an easier time getting approved for a home equity loan or HELOC if your credit is less than stellar because of the collateral involved.
That, however, is a double-edged sword. You could lose your home if you default on your home equity loan or HELOC because your property is the collateral for the loan.
And while the interest rates may be lower than other financing options, they’re not necessarily cheap solutions. These loans can come with closing costs of 2 to 5 percent of your loan amount.
Think carefully before tapping into your home equity this way. If you can, it might make more sense to save up for what you need and pay in cash.
Either way, you need to know how to smartly manage your money and your credit before taking out a home equity loan or borrowing with a HELOC. These can be helpful tools to help you leverage your cash flow — but failing to repay what you borrow could get you into a world of trouble that starts with costing a lot of money and could end with losing your home.
Should You Apply?
With the new tax law in place for 2018 and beyond, getting a home equity loan or HELOC could be more expensive than it used to be. But again, that shouldn’t necessarily change your decision either way.
The right solution for you depends on your unique financial situation and the goals you want to accomplish (or why you’re looking for financing in the first place).
Remember that you don’t have to use the same lender who underwrote your mortgage. Compare different lenders to determine which offers the best combination of interest rates and fees.
You can also skip lenders altogether and work with a home ownership investment company like Unison instead. Unison’s Home Owner program doesn’t require any monthly payments or interest fees. Instead the company invests alongside you in your home, sharing in the future change in value of the home. You can learn more here.
As you consider all of the benefits and drawbacks of taking out a home equity loan or HELOC and shop around for the best deal, you’ll be in a much better position to make a decision that suits your needs.
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