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George Saenz, the Bankrate.com Tax Talk columnistTax benefits of a home equity line of credit

Dear Tax Talk,
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?
-- Michael

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Dear Michael,
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 tax rate schedule.

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 those cars.

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.

To ask a question on Tax Talk, go to the "Ask the Experts" page, and select "taxes" as the topic.

Bankrate.com's corrections policy -- Posted: May 24, 2006
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