Chances are, you'll reach a point in life when you're inclined to borrow money for one purpose or another. You may need a loan so that you can renovate your home, fix your car, or pay for college. Or you may want that money to treat yourself to a much-needed vacation.
You have several choices for borrowing money at your disposal. Personal loans are an option if your credit score is good, and you could also charge expenses on a credit card and pay it off over time. But personal loans aren't always easy to qualify for, and credit card debt is generally bad news. That's why you might consider borrowing against your home, provided you have enough equity in it to do so. Not only is that generally an affordable option, but it may offer some tax benefits to boot.
What is a home equity loan?
A home equity loan is a loan you take out based on the amount of your home you own outright. With a home equity loan, you borrow a certain sum and then pay it back at a fixed rate over a predetermined period of time.
You may think that a home equity loan could only be used to improve an existing property, but that's not true. You can take out a home equity loan for any purpose. But a home equity loan you use to renovate your home may be deductible on your tax return.
What are the benefits of a home equity loan?
Home equity loans are attractive for a number of reasons. First, they're easy to qualify for, provided the equity in your home is there. Second, you'll generally snag a competitive interest rate on a home equity loan, and a fixed interest rate at that, making your monthly payment on that loan predictable. Finally, a home equity loan can serve as a tax deduction -- but only in limited circumstances, as we'll discuss below.
What's the difference between a home equity loan and a home equity line of credit?
You actually have a couple of choices when you're looking to borrow against your home. Your first choice is to take out a home equity loan and pay it off over time. Your second option is a home equity line of credit, or HELOC. With home equity lines of credit, you're not borrowing a lump sum upfront. Rather, you're given access to a line of credit that you can tap at any point for as long as the HELOC is active (which can be up to 10 years).
If you're not sure how much money you actually need to borrow, a HELOC may be a better choice than a home equity loan. That way, you get more flexibility, and you aren't stuck paying back a sum you don't wind up needing. And as is the case with interest on a home equity loan, interest on a HELOC is tax-deductible under certain circumstances.
How do home equity loans affect your taxes?
Most of the time, when you take on debt, it can't be used to reduce your taxable income. But in some cases, the interest you pay on a home equity loan or HELOC can serve as a tax deduction.
If you use a home equity loan or HELOC to renovate or improve your home, the interest you pay on it is tax-deductible. But if you use that money for any other purpose, it won't serve as a tax deduction. That includes home repairs -- you can't take a deduction for home equity loan interest if you use the money you borrow to fix a cracked foundation or patch up a damaged roof.
The rules surrounding home equity debt used to be different. Prior to the Tax Cuts and Jobs Act of 2017, you were allowed to take a deduction for home equity loan or HELOC interest regardless of what you spent that money on. But the tax law has since changed, and now, the IRS will only let you claim a deduction for money spent to improve your home. And to be clear, that improvement needs to be one that adds value to your home or prolongs its useful life. Finishing a basement will generally count, but cosmetic improvements like paint jobs usually won't fly.
Of course, whether you get to claim a deduction for home equity loan interest will depend on another key factor: whether you take itemized deductions on your tax return or stick with the standard deduction. If you itemize, you can reap a host of tax breaks -- you can claim a mortgage interest deduction, write off your property taxes (or a portion thereof, depending on what that number entails), and snag deductions that don't relate to homeownership, like charitable contributions.
How much of a tax break can a home equity loan give you?
Under the Tax Cuts and Jobs Act, homeowners who are married filing jointly can deduct mortgage interest on up to $750,000 worth of loans. This includes interest on a primary mortgage, a mortgage for a second home, and interest on a home equity loan or HELOC. For those who are married filing separately, that threshold is reduced to $375,000 per filer. As such, if you're married filing jointly and you already have a $750,000 mortgage, you won't be eligible to deduct home equity loan interest. Otherwise, you can deduct interest on a home equity loan that's secured by either your primary or secondary home.
Why are tax deductions valuable?
Tax deductions serve the important purpose of lowering your adjusted gross income. Say you're able to claim a $10,000 deduction on your tax return. That's $10,000 worth of earnings the IRS won't impose taxes on. The result? Added savings for you.
How do I know if I should itemize on my taxes?
Whether itemizing on your tax return makes sense for you will hinge on whether your specific deductions exceed the standard deduction, which changes from year to year. In 2020, the standard deduction is:
- $12,400 for single tax filers or those married filing separately.
- $24,800 for those married filing jointly.
If you don't pay a lot of mortgage interest, have low property taxes, and only pay a modest amount of interest on a home equity loan or HELOC, then itemizing may not make sense.
If you're not sure how your home equity loan will affect your taxes, it pays to consult an accountant or tax advisor for more information. But remember, even if you don't snag a tax break from a home equity loan, it can still be an easy, affordable way to borrow money when you need to.
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