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.