A home equity loan is a loan using your house as collateral — a somewhat risky move, but useful in some circumstances. Furthermore, you may be able to deduct the interest you pay on a home equity loan as long as you meet some requirements. Taxpayers who itemize deductions on their returns, spend the proceeds of a home equity loan to buy, build or substantially improve the property and don’t have too much total mortgage debt may qualify for this deduction.
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Home Equity Loans Basics
Home equity loans use equity in the borrower’s home as collateral. Taking out a home equity loan therefore means putting the borrower’s home at risk. If the borrower fails to pay back the loan, the lender can foreclose and sell the home to pay off the debt.
Home equity loans generally carry lower interest rates than other loans, such as unsecured personal loans, but may involve higher fees and other costs. And they are only available to homeowners who have enough equity in their homes to meet lenders’ loan-to-value (LTV) requirements. LTV benchmarks typically limit loans to 80%A fin of the home’s appraised value.
Regular home equity loans advance the borrower a single lump sum of cash. Home equity lines of credit (HELOCs) let borrowers take cash whenever they want to up to the amount of the loan. HELOC borrowers only pay interest on funds actually advanced.
Mortgage Interest Deduction Basics
The mortgage interest deduction lets homeowners who borrowed to purchase their homes deduct interest paid during a year from that year’s taxable income. However, only homeowners who itemize deductions can claim this deduction. Many opt instead for the standard deduction, which for 2022 is $12,950 for single filers and married individuals filing separately, $25,900 for joint filers and $19,400 for heads of household.
Tax law also only allows mortgage interest deductions on up to $750,000 in mortgage debt. A higher limit of $1 million applies to mortgages taken out before Dec. 16, 2017. The limit is for total mortgage debt on up to two residences.
Deducting Home Equity Loan Interest
IRS rules for home equity loans are similar in some ways to those for original loans used to purchase the home, like filers who want to deduct interest on an original mortgage, home equity borrowers have to itemize. Home equity loan interest deductions are limited to the same $750,000 in total mortgage debt. And home equity loan interest deductions can also only be clamed on qualified residences, which usually allows for a first and second home.
The big difference with home equity loan interest deductions is that they can only be claimed when loans proceeds are used for buying, building or substantially improving the property.
If a borrower uses the loan for any other purpose such as paying off a high-interest credit card balance, interest is not deductible.
Also, the loan has to be secured by the home that is being purchased, built or improved. If a borrower uses a home equity loan secured by a primary residence to buy, build or improve a vacation home, the interest is not deductible.
The tax rules don’t precisely define what amounts to a substantial improvement. However, it is generally understood to mean a permanent improvement that increases the value of the home. Examples include:
- Adding on a room, such as a bedroom, bathroom or home office
- Replacing a roof
- Constructing a swimming pool
- Upgrading or replacing a heating or cooling system
- Remodeling the kitchen
- Installing the windows
Less-permanent improvements may not qualify. For example, repainting one room probably would not be deductible. Note that the borrower should be able to connect the home equity loan proceeds to a specific improvement and keep receipts to substantiate the cost.
The $750,000 mortgage limit applies to all loans taken out on the home or homes. So a borrower with primary and vacation homes who owes a total of $500,000 on the two homes would only be able to deduct interest on a home equity loan of $250,000 or less. If a larger home equity loan is taken out, interest would be deductible only on up to $750,000 of the loans.
Home Equity Loan Alternatives
Alternatives to a home equity loan may be preferable. For instance, paying for improvements with an unsecured personal loan avoids putting the home at risk, although the interest on the personal loan is likely to be higher and also nondeductible. A cash-out refinance is another option. A homeowner who does a cash-out refinance takes out a new loan for more than the balance on the original mortgage and pockets what remains after paying of the original mortgage.
Interest paid on the amount of the refinance loan used to repay the original mortgage is tax deductible as long as the taxpayer itemizes and doesn’t owe more than $750,000 in total mortgages. After paying off the original mortgage, other funds from a cash-out refinance are, like home equity loans, only tax deductible to the extent they go to buy, build or substantially improve a qualified residence securing the loan.
Interest on home equity loans may be deductible if the taxpayer itemizes, doesn’t owe more than $750,000 in total mortgage debt and uses the proceeds to buy, build or substantially improve the property. The improvements have to be made to the property securing the loan. Other restrictions limit interest deductibility on only up to $750,000 in total mortgage loans.
Financial Planning Tips
- A financial advisor can help you with home equity loans or any other financial issues.Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- To see what your income tax payment may look like, use SmartAsset’s free tax calculator.
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