Equity loans lose tax advantages but still have a role for homeowners
How tax reform impacts home equity borrowing
- The interest on most home equity loans and lines is no longer tax deductible
- Existing second mortgages and HELOCs are not grandfathered out of the reform
- Home equity loans used for “substantial improvement” of property may still be deductible
One of the benefits of owning a home is the ability to borrow against the equity for cash to consolidate debt, make home renovations or pay college tuition. As a bonus, many homeowners had been able to write off equity loan interest on their annual tax returns.
That changed under the new Tax Cuts and Jobs Act, signed into law in December 2017.
You can still borrow against the equity, but under the new tax rules, the interest paid on most home equity loans and lines of credit is no longer tax deductible. One exception may be home equity loans used to make “substantial improvements” to a home, although as of early February 2018, the IRS has yet to clarify that rule.
The impact of the tax changes on home equity borrowing will be relatively minimal for most people, according to Jonathan Lyons, president of mortgage finance company The Lyons Group Inc. The new law nearly doubled the standard deductions, which many may find more beneficial than itemizing. Those who still do itemize may still consider tapping home equity a better option compared to other types of financing or dipping into their personal savings.
Households eligible for numerous tax deductions – such as interest deductions, charitable donations, medical expenses, etc. – for years found greater benefit through itemizing their taxes compared to the old standard deduction. The new tax code shifted that benefit somewhat. Now, the new tax rule lowered deduction limits, eliminated other deductions, and put taxpayers into different territory.
If you are considering tapping your home equity or have an existing home equity loan or line, the tax changes may influence whether it is the right financing option for you.
Tax changes for homeowners
The most far-reaching tax reform in decades, the law applies to the 2018 tax year and remains in effect through the end of 2025. For homeowners who itemize their taxes, the mortgage interest tax deduction limit was reduced to $750,000. The cap used to stand at $1 million.
Previously, homeowners could also deduct up to $100,000 in interest on home equity loans — also known as second mortgages — and home equity lines of credit (HELOCs). The new tax code eliminates this deduction on most new and existing home equity loans and lines. In other words, if you itemize your taxes and are used to deducting the interest on an equity loan, you may be in for a surprise when you complete your 2018 taxes. You probably won’t be able to deduct that interest any longer.
The big increase in the standard deduction may ease that shock, however. The new tax code nearly doubled the standard deduction, and that may impact whether you should itemize your taxes at all. For individuals, the standard deduction increased to $12,000 and for married couples, $24,000. You’ll need to have a new look at your income and all your expenses and reassess your new tax situation overall.
Have an existing home equity loan?
If you have a second mortgage or HELOC, what do you do? Your main options are to keep the loan, pay it off, or consolidate it with another loan through a refinance. The answer will largely depend on your overall financial situation. You’ll also want to consider the outstanding balance of the equity loan relative to your primary mortgage, the interest rate on both loans, and whether you continue to itemize taxes.
It may help to speak with a tax advisor to help you decide.
Consolidating existing home equity debt into a first mortgage through a refinance would pay off both loans secured by your home and replace it with a single mortgage. You will be able to deduct the interest on your primary mortgage up to $750,000, in line with the new mortgage interest tax deduction limits.
Refinancing is not always the best option, however. If you currently have a low rate and are several years into your mortgage term, it may be costlier in the long run to consolidate your loans and reset the clock on your mortgage at a higher rate. Moreover, you will be responsible for all the closing costs and fees associated with a new mortgage.
Is home equity dead?
Depending on how you use the funds, tapping home equity may remain a cost-effective option even without the tax benefits. The interest rates on a second mortgage or HELOC are often lower than other types of consumer loans, such as credit cards.
“Borrowers should look at their overall financial picture,” said Paul Risenhoover, senior loan officer at White Rock Mortgage. “If you’re carrying a lot of revolving debt and have a lot of equity in your home, (a home equity loan or line) still probably makes a lot of sense due to the rate differentials.”
If you need to make big improvements to the house, an equity loan may still be a good option.
The new tax law did not change existing language on interest deductions on home equity loans or HELOCs if the money is used to make “substantial improvements” to a primary residence, so long as your total debt for your mortgage and the equity loan doesn’t exceed the $750,000 limit.
The means test for what constitutes “substantial” is not yet clear as it has not been put into practice, Lyons said. Until the law is formalized by the IRS, consult a tax professional before taking action.
“There will be some kind of deduction if you keep good track of your spending on home improvements,” Lyons said.
If you’re concerned you won’t meet that standard, a cash-out refinance is an alternative way to tap home equity. With a cash-out refinance, you replace your existing mortgage with a higher loan amount, and you receive the difference in cash. As a first mortgage, interest on cash-out refinances remain tax-deductible up to $750,000. If you need a large amount of money and have enough equity in your home, a cash-out refinance could help you access tax-advantaged financing.
Refinancing your mortgage is a long-lasting, consequential decision, however. You replace your existing mortgage, taking on a new interest rate and loan terms, which may not be an improvement for you. You will also have to pay mortgage closing costs and fees, which can total several thousand dollars, depending on the loan amount.
Second mortgages to avoid PMI
The tax changes on home equity debt also may put some homebuyers in the position of choosing between whether to take out a second mortgage to finance a down payment or pay private mortgage insurance in their monthly payments, according to Sam Yow, vice president of mortgage company Homeside Financial LLC.
Homebuyers sometimes take out a second mortgage along with a primary home loan as a way to make a 20 percent down payment — thus avoiding paying private mortgage insurance, which can add hundreds of dollars a month to the mortgage payment. This strategy is most often used in high-cost markets, and the second mortgage is typically interest-only. Under the previous tax rules, these second mortgages were also deductible. No more.
“The elimination of tax deductibility on second mortgages tilts the options closer to paying mortgage insurance, particularly for high-balance borrowers,” said Yow, adding that the cost of mortgage interest has declined in recent years. “A second trust product in the past five years was attractive on purchases to avoid mortgage insurance, but now it is worth looking at both options and evaluating the overall rate and overall cost, in addition to tax deductibility.”
Tax deductibility is not the only reason for taking out or sustaining a loan. Homeowners should assess how the tax reforms affect their entire financial picture before making a borrowing decision.
With the stock market performing well, according to Lyons, it may not make sense to pull money out of investments or savings to finance a purchase when you have a relatively low-interest rate loan. Although new loans may cost more in a rising interest rate environment, your investments will be rising as well.
“Borrowers always have to look at the interest rate and cost of borrowing versus using savings,” said Lyons.