Should You Be Paying Off Your Home Equity Loan Sooner?
February 27, 2018When it comes to the new tax law, by now you have most likely already heard that the income tax brackets were lowered, standard deductions increased, and there is a cap on state and local tax deductions. But there is another major change that could have an effect on your personal finances. The tax reform law alters the ability to deduct interest on home equity loans or home equity lines of credit.
Changes to the mortgage interest deduction
The newly-enacted law places restrictions on home mortgages. The first restriction affects people who purchase a home between now and 2026 — basically you can only deduct interest paid on up to $750,000 in mortgage debt. The second part is that mortgages eligible for the itemized deduction must be used to purchase or improve it, including a home equity loan or HELOC (home equity line of credit). (Note that if you took out your mortgage on December 14, 2017 or earlier, you will still be able to deduct interest on up to $1 million in debt, but the home equity loan restriction affects all outstanding loans)
Can I still deduct my home equity loan interest?
Because of the way the law is worded, it was initially assumed by many that if you have a home equity loan or line of credit with a balance, that the interest you pay would no longer be deductible as mortgage interest. However, this may not be true in all cases — according to recent IRS guidance, in many cases you can continue to deduct interest paid on home equity loans, as long as they were used to buy, build or substantially improve the home that secures the loan.
Deductible versus non-deductible
For example, if you use a home equity loan to build an addition to your home or complete major renovations, the interest is likely deductible. But if you use a home equity loan to consolidate credit card debt or pay for your pet’s trip to the vet, you will not be able to claim the mortgage interest deduction. A loan is deductible if it is secured by your main home or second home (known as a qualified residence) and does not exceed the cost of the home and meets other requirements.
When to re-prioritize debt paydowns
If you are no longer eligible for the home equity interest deduction, you may need to re-prioritize paying it down, but it’s important to look at the big picture. Since home equity loans and HELOCs often offer lower interest rates, you first need to consider your overall financial wellness before redirecting dollars to paying down home equity debt.
Focus on this first
In general, you should have a fully funded emergency fund, save enough to capture any matching contributions in an employer’s retirement plan, and eliminate higher interest debt such as credit cards or personal loans before paying down your home equity loan or line of credit (see Financial Priority Checklist).
Making your money work hardest for you
If you already have your financial foundation in place your decision really comes down to where your money will work hardest for you. Financially speaking, your decision should be based on your after-tax cost of borrowing versus your after-tax return on your investments. If you are no longer able to deduct the interest on your home equity debt then your actual interest rate will become the main point of comparison.
However, if you have a variable interest rate you must also consider the significant likelihood of your interest rate creeping higher in the near future with the possibility of rising rates. There is also something to be said about the emotional aspect of eliminating debt. Paying off your home equity loan or HELOC ahead of schedule makes sense if it frees up cash flow to help you focus on future life goals such as paying for college or transitioning to retirement.
As you can see, a lot has changed as a result of the recent tax law reform. One thing remains the same – you must constantly review your own financial plans to see how these changes will affect you.
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