Debt and Income Tax Laws

The cost of credit increased with the passage of the Tax Reform Act of 1986, because since that time the interest paid on your auto, credit cards, education and other consumer loans is no longer deductible on your tax return.

In addition, there is only a certain amount of qualified residence (mortgage) interest that is deductible. Qualified residence interest is the interest paid or accrued on acquisition or home equity loans on respect to your principal residence and one other residence, usually your "vacation home." The total amount of acquisition loans is limited to $1 million and the total amount of home equity loans is limited to $100,000. Interest on any debt over these limits is considered to be personal, consumer interest that is not deductible.

Is it a good idea to take out a home equity loan? Should you convert your consumer loan interest into interest on a home equity loan in order to be able to deduct your interest? Before you join the rush to a home equity loan, you should consider the pluses and minuses.

Many credit counselors advocate the general rule that you should not convert unsecured debt into secured debt. Following this rule would mean not using your home equity to collateralize your credit card debt. Although this is certainly a logical and prudent rule, like most general rules, we think there are times where exceptions may be in order. For instance, such a loan may be appropriate if most or all of the following factors are true:

• You have home equity that you can tap into.
• You presently have been able only to make the minimum monthly payment required on your credit cards.
• Your credit card debt carries very high interest compared to what you could obtain for a home equity loan
• You would meet the qualifications that would make interest to be paid on the home equity loan deductible on your federal income tax return
• You will pay back the home equity loan on a relatively short payment schedule — probably five years, but no more than 10 years. (If this doesn't seem short, remember: if you are only paying the minimum monthly amount required on a large charge balance, your account may not be paid in full for 20 years or more!)
• You have an adequate and dependable source of income available to repay the home equity loan.
• Probably most importantly: You have made the necessary adjustments to your lifestyle and personal finances necessary to ensure that you won't slide back into the credit card debt morass once your existing credit balances are extinguished.