(i) I bought a house just after I got married 3 years ago.
My existing mortgage balance is $60,000. I have just put
$20,000 into it using various credit cards. The house is
now appraised at $145,000. What are the loan interest
items eligible for tax deduction?

(ii) If I take out a $20,000 home equity loan to pay off
my credit card debt, would my interest deduction be
different?

(iii) If, in addition to (ii) above, I take out a $96,000
cash-out mortgage refinancing loan to refinance my existing
mortgage, and use the excess cash of $36,000 (ie $96,000
less $60,000) to improve my house. How would this affect
my interest deduction?

(iv) Assume that I don’t act on (ii) and (iii). Instead,
I take out a 110% home equity loan to pay off my credit
card debt of $20,000, and lend the balance of $79,500 to my
parents to buy a house. What would my mortgage interest
deduction be like?
.
.
Whether or not your home mortgage interest is fully
deductible depends on:

(a) the date you took out the mortgage. October 13, 1987
is the important date.
.
(b) the amount of the mortgage
.
(c) how you use the proceeds of the mortgage
.
.
Let’s consider your four scenarios.
.

Scenario (i)
————
Mortgage interest is fully tax deductible if a home
mortgage is home acquisition debt as defined by the IRS.
Home acquisition debt is a home mortgage that:
.

(I) you took out after October 13, 1987, and
.
(II) you used it to buy, build or substantially improve
your qualified home (your main or second home), and
.
(III) is secured by that home.
.

Your $60,000 mortgage satisfies conditions (I), (II) and
(III), and therefore the mortgage interest on the $60,000
loan is fully deductible.
.

Your credit card debt $20,000 is not home acquisition debt
because it does not satisfy condition (II) — you have not
stated whether the $20,000 was used to build or to
substantially improve your home — and condition (III).
Therefore your credit card interest is not tax deductible.
.

—- Sidebar —-

There is a limit on home acquisition debt. The total
amount you can treat as home acquisition debt at any time
on your main home and second home cannot be more than $1
million (or $500,000 if you and your spouse filing
separately). If your home acquisition debt exceeds the
limit, the maximum deductible interest is that charged on
$1 million (or $500,000 if you and your spouse filing
separately).

—- End of sidebar —-
.
.
Scenario (ii)
————-
The IRS defines another type of loan as home equity debt.
Home equity debt is a home mortgage:
.

(A) you took out after October 13, 1987, and
(B) does not qualify as home acquisition debt, and
(C) is secured by your qualified home (your main or second
home)
.

Your $20,000 home equity loan used to pay off your credit
card debt satisfies conditions (A), (B), and (C) above, and
therefore is home equity debt under the IRS definition.
Therefore the interest on your $20,000 home equity loan is
fully tax deductible. Note that for what purposes home
equity debt is used is not relevant.
.

—- Sidebar —-

There is also a limit on home equity debt. The conditions
are:

1. The total home equity debt on your main and second
home cannot exceed $100,000 (or $50,000 if you and your
spouse filing separately), and
.
2. your home equity debt + your home acquisition debt +
your [tag]grandfathered debt[/tag] must not yield a total sum that
exceeds the fair market value of your home (grandfathered
debt is simply mortgages you took out on or before October
13, 1987). See scenario (iv) discussion below for further
clarification.

—- End of sidebar —-
.
.
Scenario (iii)
————–
Based on the conditions discussed in Scenario (i), the
entire $96,000 is home acquisition debt. Therefore the
interest on the $96,000 cash-out mortgage is fully
deductible.
.

Home acquisition debt + home equity debt = $96,000 +
$20,000 = $116,000, ie less than your home’s fair market
value of $145,000. Therefore the $20,000 home equity debt
is within the allowable limit, and so the interest on the
$20,000 is fully deductible.
.
.
Scenario (iv)
————-
Let’s set out the numbers:
.

.. Your home’s fair market value = $145,000
.

.. 110% x $145,000 = $159,500.
.

.. Your existing mortgage balance = $60,000
.

Therefore your home equity loan = $159,500 less $60,000 =
$99,500
.

The $79,500 you lend your parents is not home acquisition debt for tax purposes as the house belongs to your parents, and the house is thus not your qualified home. Therefore the entire $99,500 is your home equity debt for tax purposes.
.

Let’s recap the conditions for home equity debt:

(aa) it is taken out after October 13, 1987, and
.
(bb) it is secured by your home, and
.
(cc) it does not exceed $100,000 (or $50,000 if you and
your spouse filing separately), and
.
(dd) your home equity debt + your home acquisition debt +
your grandfathered debt must not yield a total sum greater
than your home’s fair market value.
.

Your home equity loan of $99,500 satisfies conditions
(aa), (bb), and (cc), assuming you and your spouse don’t file
separately. But it does not satisfy condition (dd) because:
.
home equity debt + home acquisition debt +
grandfathered debt = $99,500 + $60,000 + $0 = $159,500,
exceeding your home’s fair market value of $145,000.
.

Therefore your maximum eligible home equity debt under condition (dd) = $145,000 less 60,000 = $85,000.
.
Now the figures under condition (dd) look like this:
.
home equity debt + home acquisition debt +
grandfathered debt = $85,000 + $60,000 + $0 = $145,000
.
In other words, you are allowed to claim tax deduction for loan interest paid on only $85,000 of your $99,500 home equity loan.
.

Next, you have to test again to see if condition (cc) is satisfied. Now compare the result ($85,000) with condition (cc), ie $85,000 vs $100,000. Since $85,000 does not exceed the threshold of $100,000, the eligible home equity debt for tax purposes is the lower of the two, ie $85,000.
.

Summary for scenario (iv)
—————————————
(1) The interest on your existing mortgage balance of
$60,000 is tax deductible.
.
(2) Of the $99,500 home equity loan, only $85,000 qualifies as home equity debt under the IRS definition, and the interest attributable to $85,000 is tax deductible.
.
.

Tags: grandfathered-debt, home-acquisition-debt, home-equity-debt, loan-interest-deduction, qualified-home, tax-deductible, tax-deduction

[tag]Home equity loan[/tag]

You should bear in mind that you will still be in debt: you will be in a home equity loan debt although you will be free of your credit card debt.
.
If you really can’t afford the monthly payment for your $10,000 [tag]credit card debt[/tag], getting a home equity loan to replace it may be justifiable because there are some advantages:
.
(a) home equity loan interest rates are lower than credit card interest rates. So you will be using a cheaper debt (home equity loan) to retire a more expensive debt (credit card debt)
.
(b) home equity loan interest rates are fixed, and therefore you are free from the risk of unexpected interest rate hike. The monthly repayment instalment is also fixed, thus making it easier for you to plan your cash flows
.
(c) the longer the home equity loan period, the lower the monthly repayment instalment. Therefore you can choose a loan period that gives you a low monthly repayment instalment that you are comfortable with. But the trade-off is that the longer the period, the more cumulative loan interest you will pay.
.
(d) the interest you pay on the home equity loan is [tag]tax deductible[/tag], whereas your credit card interest is not.
.
But do you have the cash to pay for the costs of taking out a home equity loan? You should find a trustworthy lender to determine exactly how much cash you have to cough up to cover the costs of taking out the home equity loan.

.

Reducing your credit card limit

If you do replace your credit card debt with a home equity loan, don’t start spending on your credit card again without discipline to build up another beyond-your-means credit card debt. Don’t let the home equity loan make you feel rich.
.
Cutting up your credit card and paying for everything by cash is the best discipline, but it may not be practical for you. If you find it difficult to muster self-discipline to curb your credit card spending, you may have your credit card limit reduced to prevent you from overspending. But the resultant drawback is that this will affect your [tag]credit score[/tag] negatively.
.
The [tag]FICO[/tag] formula, created by Fair Isaac Corp., likes a nice, wide gap between any balances and the limits on your credit cards. In other words, it likes a low utilization rate on your credit card limits. Lowering your credit limit would reduce that gap and could have a negative impact on your score. (Credit scores, in case you don’t know, are three-digit numbers that lenders use to help gauge your creditworthiness. The FICO is the leading credit score system.)
.
For example, if your credit card limit is $8,000 and your credit card debt is $2,000, your utilization rate is 25% (2000 � 8000 � 100% = 25%). If you reduce your credit card limit to $4,000 and your credit card debt remains at $2,000, your utilization rate rises to 50% (2000 � 4000 � 100% = 50%), ie the gap is reduced. This high ratio may be interpreted to mean that you are living closer to the edge.
.
If your credit scores are good, you needn’t worry about lenders balking because you have “too much” available credit. If your scores aren’t good, you don’t want to imperil them further by shutting down or reducing your credit lines.
.
You have two other possible alternatives to raise the cash you need to pay off your credit card debt, viz. life insurance loan and personal loan.

.

[tag]Life insurance loan[/tag]

If you have life insurance policies, you may borrow against the accumulated cash value at relatively low interest rates. Essentially, you are borrowing from your own savings. Interest rates may be fixed or variable depending on the policy.
.
Life insurance loans can be a convenient way to borrow money, especially if the interest rate is low. These loans do not have to be repaid, but keep in mind that the outstanding balance will be deducted from the death benefit the beneficiary will receive when you die. It is important that you at least pay the interest as it comes due, since interest will continue to compound on the interest owed on the loan.
.
CAUTION!: If you use the cash value in your insurance policy to pay the interest on a life insurance loan, you may use up all of your cash value, which can cause your policy to lapse.

.

[tag]Personal loan[/tag]

There are many different types of personal loans (or [tag]consumer loans[/tag]) that you may be able to get if you are unable to take advantage of a home equity loan or a life insurance loan discussed above. They may be secured or unsecured.
.
You may consider taking an [tag]unsecured personal loan[/tag]. Since you are a home owner, in the eyes of the lender you are solvent, ie your home ownership implies that you have the ability to meet your financial obligations on time.
.
Your home ownership also implies that in case you cannot afford the monthly payments and the lender has to resort to legal means to recover his money, there are more probabilities he will be able to get enough money from your assets to recover the amount owed and any legal fees he might incur.
.
You will be charged a fixed interest rate on your unsecured personal loan. Your monthly repayment instalments will also be fixed. You may choose a loan period that gives you a low monthly repayment intalment that you are comfortable with. Of course the longer the loan period, the lower the monthly repayment instalment, but you will pay more interest in total.
.
Personal loans are the least favorable way to borrow money, since they typically carry very high interest rates.
.
The interest charges on personal loans are not tax deductible.

Tags: consumer-loans, credit-card-debt, credit-score, fico, home-equity-loan, life-insurance-loan, Personal loan, tax-deductible, unsecured-personal-loan