You probably know of the tax benefits you receive from your first mortgage. The interest is tax deductible. This means you owe less tax. What if you have a HELOC, though? Are those interest payments tax deductible? We explain the benefits here.
How do you Use the Proceeds?
The first question you must ask yourself is how you used the proceeds of the HELOC. There are many different uses for them. A few examples include:
- Help with the down payment on a home purchase
- Make home improvements
- Consolidate credit card debt
- College tuition
- Medical bills
- Emergency fund
You should categorize how you use your proceeds based on whether it has an impact on the house or not. For example, using it for down payment money obviously directly impacts your home. Using the proceeds to consolidate your credit card debt does not. Now we will look at how the use impacts your taxes.
HELOC for Down Payment Money
It is not uncommon for borrowers to secure a HELOC for down payment money. In mortgage terms, this is called a piggyback loan. It piggy backs on your first mortgage and the money you put down yourself. Here’s a common example:
John wants to purchase a house for $150,000. He has $15,000 to put down on the home. But, John doesn’t want to pay PMI. He knows it will add up over the course of the loan. Plus, he doesn’t want to make his mortgage payment any larger than it already is. John needs another $15,000 in order to satisfy the $20,000 down payment. He can get this money from a HELOC. $15,000 would equal 10% of the purchase price of the home. This is where the loan gets the name 80-10-10. 80% comes from the 1st mortgage; 10% comes from the 2nd mortgage; and the remaining 10% comes from your funds.
In this case, you could deduct every penny of interest you make. This mirrors what you could do on your 1st mortgage.
HELOC for Home Improvements
Just like the money you used to purchase your home, a HELOC is tax deductible when you use the funds to fix up the home. The changes you make must directly impact the home, though. Think of things like remodeling a kitchen, adding a bedroom, or replacing the roof. These are things that will remain on the house whether you stay or not.
There isn’t a dollar amount you must stick to – you can write off the interest on these payments. Where it gets tricky, though, is when you don’t use all of the funds for home improvement. Let’s say you took out $50,000 in a HELOC. You used $20,000 for home improvement, but used the other $30,000 for other uses. You can’t write off the entire $50,000. You can write off 100% of the interest on the $20,000. The rest is a little trickier.
Are Other HELOC Uses Tax Deductible?
You can use the proceeds from a HELOC for pretty much anything. A lender might ask why you want it prior to approval. But, once you have it, it is yours to use. Certain uses may not be tax deductible. Things like college tuition, medical bills, or consolidating debt, are a few examples. In this case, you can only deduct for a loan amount up to $100,000, this doesn’t get you far.
Even if you took out a HELOC for only $100,000, but you use it repeatedly, you can’t write off the interest after the first $100,000. This is a common scenario.
Borrowers take out a HELOC to consolidate high interest credit card debt. They don’t want to pay the crazy interest rates anymore. They know they can get a lower rate with their HELOC. They pay the credit cards off with the new mortgage. They then pay the line down. With more available credit, they use it for other things. It could be a new car, home improvements, a vacation, or anything else. The money is not tax deductible unless it is an expense for the house.
What Should You Do?
Before you decide to get or not get a HELOC, consider your options. First, consider how you will use it. If it’s to avoid PMI for a house purchase, it could be well worth it. You save money every month and get the tax write-off. PMI is not tax deductible, so this situation makes sense.
Even if you plan to make home improvements, a HELOC can make sense. While you might be able to use credit cards, they often charge higher interest rates. Their interest is also not tax deductible. If you can refrain from using the line for anything else after you pay it down, this could be a good option.
If, however, you want to use it for anything else and you don’t have a great financial history, you may think twice. Defaulting on your HELOC could put your home at risk. Plus, you don’t get to write off the interest beyond $100,000. This could make the line of credit much more expensive than it needs to be.
If you do choose to take out a HELOC, shop around. Many lenders offer different programs. Find the interest rate and costs that fit your needs the best. If you have great credit, you may be able to secure a home equity line of credit with a very low interest rate and low costs. Some lenders even offer them for free for existing customers.
Make sure you explore all of your options. You may even want to talk to your tax professional before you decide what to do. This way you know the full tax implication of taking out a HELOC. You should understand not only how it works, but also what happens with future use. Your hard work will pay off as you minimize your tax debt and increase your financial stability.Click to See the Latest Mortgage Rates»