Home Equity Loans - Pros and Cons

A home equity line of credit (HELOC) used to be easy to get and probably will be again once the mortgage mess clears up and home values begin to appreciate.

Having a home equity line of credit can be useful for emergencies especially since using it costs so little. The interest rate on mine is 2.25% currently. Instead of using a margin loan at Schwab, I took out a loan against the equity line saving about 5%.

The trick with using the equity line is to make the interest deductible. Most of you know interest on the first $100,000 of a home equity loan is deductible. What you may not know is that the interest is subject to Alternative Minimum Tax (AMT) and since most of my clients are paying AMT every year, then their HELOC interest is not reducing the income taxes owed.

One way to avoid the AMT issue is to use the home equity loan proceeds for something that makes it deductible. Examples are:

• use the proceeds for rental property
• use the proceeds for investment
• loan the proceeds to your LLC or corporation

Using the HELOC for these ideas requires tax planning and perhaps a formal election. Check with your tax preparer before taking action.

A few more pitfalls:

• home equity loan interest is not deductible to the extent that all the home loan debt exceeds the fair value of your home
• itemized deduction phaseouts may reduce the value of the HELOC interest deduction even if you are not subject to AMT

Having a large and permanent home equity loan balance is not advisable because the interest rate is variable and if you can't pay the loan back easily, then big increases in the rate could take a surprisingly large chunk out of your cash flow.