Home equity is simply the amount of your current home that you have already paid off. For example, if your home is worth $300,000 and your mortgage still has a balance of $150,000, then you have $150,000 of equity in your home. Your home equity will increase when the value of your home increases; you don't acquire it solely by paying off your mortgage. If your initial mortgage balance was $250,000, then you gained $50,000 of equity from market appreciation. Home equity is always listed as an asset on the balance sheet, and it is often one of the most significant assets in many U.S. households. It may also constitute the key value of any real estate that you own.
Before Trump’s tax laws took effect, borrowers could deduct the interest paid on a first mortgage of up to $1 million. Home equity loan and home equity line of credit interest was also deductible as an itemized deduction, regardless of what the loan proceeds were used for. But Trump’s new tax laws have changed all of that. Now only the interest paid on first mortgages of $750,000 or less is tax deductible. The loan balance for home equity loans and lines of credit is capped at $100,000, but more importantly, interest on any type of second mortgage is now only deductible if the loan proceeds are used to build, buy or substantially improve the residence that the is taken out against. This is a major new limitation for taxpayers, as this means that home equity loans and lines of credit that are used for such purposes as debt consolidation, medical or educational bills now charge nondeductible interest. These limitations will most likely make a noticeable dent in the number of taxpayers who are able to itemize deductions from now on.
In many cases, borrowers are at liberty to use either type of loan when they need cash. But knowing which type of second mortgage to use is not always easy. In some situations, there are clear-cut reasons to use one type of loan over the other, but many times this is a gray area where the advantages and disadvantages of each type of loan must be carefully considered before signing on the dotted line.
When A Home Equity Loan May Be Better
If you need a single, predetermined amount of money up front and don’t expect to need more in the future, then a home equity loan is probably going to be the better choice. The rate of interest that this loan charges will be higher than a home equity line of credit will charge, but it will be a fixed rate of interest that will not fluctuate with prevailing interest rates. This type of loan is also appropriate when interest rates are rising, as the borrower may eventually end up paying less interest on the loan than they would with a line of credit. For example, if the Prime Rate is 3% when you take your home equity loan, then you might pay an annual percentage rate of 8% over the life of the loan. But if interest rates then rise to 11 or 12%, then you may come out ahead of someone who used a line of credit instead.
When a Home Equity Line of Credit May Be Better
A home equity line of credit may be the better choice for you if you are going to need to draw out funds from your second mortgage on a periodic basis. For example, if you will need to make periodic withdrawals to pay for college tuition or make home improvements, then a line of credit definitely makes more sense than a home equity loan.
A home equity line of credit may also be the better choice if you know that your income is going to increase sometime in the near future. If your budget is tight right now and interest rates are low, then you might consider taking out a HELOC that charges interest-only payments for a set period of time before starting to require the repayment of principal. If you know that you are going to be promoted at your job, then you should be able to cover the new higher payments with the raise that you receive.
Of course, some situations are more complex than the ones outlined here, and in those cases it would be wise to seek professional help from a mortgage broker or financial planner in order to make the choice that’s best for you.