benefits of a home equity line of credit
We have two car loans, the interest of which is approximately 6.5
percent. We thought it might be a good idea to take out an equity
line of credit, pay off the vehicles and do a small remodel on our
bathroom. However, after checking the interest rate (8 percent)
on a line of credit loan, I now wonder if the tax savings would
outweigh the difference in interest rates?
Since car loan interest is not deductible and mortgage interest
is -- within certain limits -- you have to weigh the after-tax benefit
of the mortgage interest deduction against the cost of your car
loans. (Remember algebra?) You can usually deduct the interest on
up to $100,000 of home equity borrowing used for any purpose, such
as paying off a car loan. The $100,000 can be increased for any
borrowing used to improve your home, such as the bathroom remodeling.
For example, if you borrow $120,000 and use $100,000 to pay off
car loans and $20,000 to remodel the bathroom, the interest on the
entire $120,000 would be deductible as home mortgage interest.
If you are already itemizing your deductions, calculating
the after-tax benefit of the home equity borrowing is fairly straightforward.
To determine your after-tax interest rate, you need to know your
marginal tax bracket. Your marginal tax rate is the federal and
state tax rates combined that apply to the next dollar of income
you earn or that you can deduct. To find your 2006 federal marginal
rate, look at your 2005 taxable income (assuming your annual income
is level from one year to the next) and see where it falls in the
For most folks, federal rates fall between 25 percent
and 35 percent. State rates vary, but let's assume for illustration
that your federal rate is 28 percent and your state rate is 5 percent
so that, combined you have a 33 percent marginal rate. Your home
equity borrowing after-tax interest rate is the inverse of your
marginal rate (67 percent) multiplied by the equity line's interest
rate (8 percent in your case). The result is 5.36 percent, which
is slightly better than the car loan rate.
Forgetting about algebra, you next have to weigh all
the other costs involved, such as loan costs, and consider the consequences
of borrowing against equity, which may extend the time you pay for
Bottom line: If you have $1,000 in car loan interest
per year and you can better it by about 1 percent, you're only talking
about $114 in tax savings versus after-tax interest rate costs ($536
versus $650). If you use the standard deduction rather than itemize
your deductions, the savings, if any, would be negligible.
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