Invest proceeds from home equity loan or pay it off? itt

[nico08]

I have an equity line of credit with penfed. Today was the last day of a promotional that locked in 1.99% interest for two years on a home equity loan. I obtained a loan on the line of credit today. My thought was that I could deduct the interest on this loan, and that I could find some type that of investment that would yield something higher than 1.99%. Well, a quick look at CDs does not seem to show a 2 year CD with a greater than 2 percent yield. Even the short term bond fund that I have with Vanguard has not yielded more than 1.99% in the past year.

So I question whether my idea of making a small, relatively safe investment profit from the loan proceeds as well as a tax deduction. Do you think I should just pay off this home equity loan ASAP and chalk this up to experience? I was told I would not pay any penalty for paying the loan early.

 

[Meadbh]

If you have a loan with an interest rate greater than 1.99%, you could use the loan to reduce that debt. The one caution would be to account for tax deductibility if the loan is a US home mortgage.


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[nico08]

If you have a loan with an interest rate greater than 1.99%, you could use the loan to reduce that debt. The one caution would be to account for tax deductibility if the loan is a US home mortgage.


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Hi Meadbh:

Thank you for your insight. So if I have a mortgage with an interest rate that is higher than 1.99%, it would make sense to apply this home equity loan money toward that mortgage?

Is there anything that would prevent the 1.99% home equity loan interest from being tax deductible?

 

[Meadbh]

Please bear in mind that I don't live in the US and am not an expert on US taxes. I do not know whether interest on a HELOC is tax deductible in the US.

You really need to know the effective after tax rate of both your mortgage payments and the HELOC.

Let's suppose, just for purposes of illustration, that your mortgage interest rate is 6%, that it is tax deductible, and that your marginal income tax rate is 50%. Let us assume that the HELOC is not tax deductible. The effective after tax interest rate of your mortgage is 3%. Paying down some mortgage principal with money borrowed at 1.99% gives you a guaranteed net return of 1.01%, provided that you pay off the HELOC at the same rate.

OTOH, if you currently have a mortgage at 3%, and your marginal income tax rate is still 50%, the effective after tax interest rate on your mortgage is only 1.5%, and there is no benefit to paying down principal with the non tax deductible HELOC.

If both the mortgage and the HELOC interest are tax deductible, it's a much simpler decision. If the mortgage interest rate is higher, it's a great opportunity to pay down some principal.

The details matter.

 

[nico08]

After 2 years, the home equity loan interest amount changes from 1.99% to prime + 1 percent. So I am not sure if there is a low risk way to earn any sort of profit in this scenario?

 

[Animorph]

Yeah, you have to make sure your time horizon matches the loan. I wouldn't put it in the current stock market, being somewhat of a pessimist.


As far as taxes, you get up to a $100k deduction of interest for a mortgage equity loan for standard taxes. For AMT you don't get that. However, if you use the loan for investments, then you can deduct the interest for AMT as well, providing you can show income which I think has to exceed the interest deducted (Turbo Tax hasn't complained about that for a while now). Leave a clear paper trail in that case.