Understanding Home Equity Loans and Lines of Credit

Foreclosure and taxes

With both home equity loans and HELOCs, your home is collateral for the loan. If you don’t pay your primary loan or your equity loan, a lender could foreclose and seize the property.

Although you may have heard that the interest on home equity loans and HELOCs is usually tax deductible on loans up to $100,000, that’s not quite the full picture. In truth, the interest you pay on a mortgage up to $1 million is tax deductible. If you have a home equity loan, that overall mortgage limit gets bumped up by $100,000 to $1.1 million, according to Rob Seltzer, a CPA who runs a firm bearing his name in Los Angeles.

So you might have a high-value property — worth, say, $650,000 — and you may have a $250,000 first mortgage on it and a $200,000 line of credit as well. Under this scenario, you’d have $450,000 in mortgage debt outstanding, and because you’re well under the $1.1 million mortgage limit, the interest you pay on both loans would be tax deductible, Seltzer notes.

Watch out for the lure of minimum payments

If you decide to tap your home equity in order to consolidate debt, recognize the pros and cons of doing so.

“Home equity is a great tool if it’s used responsibly,” says Seltzer, “but it can also be a trap.”

People looking to consolidate debt, such as credit cards or auto loans, benefit in two ways: “With home equity loans and HELOCs, you’re not only getting a lower rate, you’re also making payments that are tax deductible.”

The downside, however, is that equity lines of credit only require you to pay interest in the early years of the loan. “People need to have discipline and not just essentially make minimum payments on HELOCs,” he says.

Lorsch agrees, noting that’s another way in which HELOCs can act like credit cards.

“During the first five or 10 years, during the draw period, most lenders only require you to pay interest, and many people do in fact only pay interest, not principal on HELOCs,” Lorsch says. “But you can always pay more.”

Lynnette Khalfani-Cox, The Money Coach(R), is a personal finance expert, television and radio personality, and regular contributor to AARP. You can follow her on Twitter and on Facebook.