Should You Be Paying Off Your Home Equity Loan Sooner?

February 27, 2018

When 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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How to Avoid Borrowing From Your Retirement Plan

January 26, 2017

Have you ever borrowed from your employer’s retirement plan? When you need cash in a hurry, it can be tempting. After all, you don’t have to worry about a credit check and the interest just goes back into your own account.

However, there are a couple of reasons why this may not be the best idea. First, you lose any gains your money would have earned. Keep in mind that the stock market averages a 7-10% return per year, including many years with double digit returns so you could be losing out on real money.

Second, if you leave your job before paying off your loan, the outstanding balance could be considered a withdrawal and subject to taxes plus a possible 10% penalty if you’re under age 59 ½. These losses could end up jeopardizing your retirement. Here are some ways to avoid having to raid your retirement nest egg in the future:

Don’t think of your retirement account as a giant ATM. Even if your plan allows it for any reason, retirement plan loans should only be for dire emergencies and no, wanting the latest tech gadget or a vacation doesn’t qualify. Instead, calculate how much you need to save each month and have that amount automatically transferred to a separate savings account until you have enough to purchase what you want. Don’t have enough to save? Ask yourself what expenses you’re willing to cut back on to make your goal happen.

Have an emergency fund. Even if you do have an emergency, a retirement plan loan shouldn’t be your first resort. If your investments are down in value, you may not even have enough to borrow. Instead, build up enough savings to cover 3-6 months’ worth of necessary expenses and keep that money someplace safe like a savings account or money market fund. If you can’t stand the idea of all that cash just sitting there earning less than 1%, here are some ideas to put it to work harder for you.

Consider other options. For example, the average home equity interest rate is about 5%. Don’t forget that it’s tax-deductible too. If you’re in the 25% tax bracket, that loan may only cost you 3.75% after taxes, which is less than your investments will probably earn. Just be aware that your home is on the line if you can’t make the payments so this is probably not be a good idea if you’re facing severe financial hardship.

One final point is that people sometimes use a retirement plan loan to pay down credit card debt. Given how high credit card interest rates can be, this might be a smart move if it’s part of a larger plan to become free of high-interest debt. However, if you end up filing for bankruptcy, you’ll still have the retirement plan loan. In that case, you would have been better off using the bankruptcy to wipe out the credit card debt and leave your retirement account alone. (It’s generally a protected asset in bankruptcy.)

Retirement plan loans have a place, but be aware of the downsides. If you’re not sure what to do, consider consulting with a qualified financial planner. As with any financial decision, you want to make an informed one.

Consolidating Isn’t Always Easy

November 20, 2015

As I was whining about not having a topic to write about, I got this email in my inbox:

I’ve got a co-worker who wanted to consolidate his credit card debt into one manageable loan with a lower interest rate.When he started looking though, he continued to find either consolidation loans with higher interest rates than his credit cards or he’d find what he calls “scam artists” that claim to try to find consolidation loans that he would be eligible for but then would say that he wasn’t eligible for them or they were for a “3rd party investor loan.” (Don’t really know what he meant by that.) I said I’d help him find reputable companies and I did. BUT that’s hard to do with all of the information – good and bad – on the Internet.

Boom! That’s a real life blog topic…. Continue reading “Consolidating Isn’t Always Easy”

Finding Some Good In My Worst Financial Decisions: Part 3

November 09, 2015

During the last few weeks, I’ve pointed out some of my own financial failures. Well, these failures weren’t exactly complete financial fails because I learned something from them and moved forward with a greater sense of purpose for how to better use wealth to accomplish life goals. Perhaps it is the voyeuristic culture that we live in with constant social media updates and reality TV shows that condition some of us to enjoy seeing others make mistakes right in front our eyes. I don’t know what that really says about our society, but it may just make us feel better to see that others are a little more messed up in the head than we are. Continue reading “Finding Some Good In My Worst Financial Decisions: Part 3”

How to Manage Student Loan Debt in Retirement

October 14, 2014

You’ve worked hard both in the professional world and at home raising your family and retirement is just around the corner. Now it is your turn to relax – somewhat — and do the things you love and want to do. But what if you haven’t finished paying off your student loan debt? Continue reading “How to Manage Student Loan Debt in Retirement”

3 Alternatives to Borrowing From Your 401(k)

July 10, 2014

Last week, I wrote about some reasons it might actually make sense to borrow from your 401(k). After all, there’s no credit check and the interest goes back into your own account. But even in those situations, there may be better options. After all, borrowing from your 401(k) means your money isn’t growing for retirement, the money generally has to be paid back over a relatively short 5 year period, and the outstanding balance could be subject to taxes and penalties if you leave your job. Here are three alternatives along with their pros and cons relative to a 401(k) loan and a couple of sites you can use to find them: Continue reading “3 Alternatives to Borrowing From Your 401(k)”