Transforming Nondeductible Personal Debt into a Tax Deduction

Interest on personal credit card debt is not deductible. However, homeowners are in a unique position to reduce their monthly payments and at the same time transform this debt into a tax deduction. Here’s what you need to know.

A homeowner can use the equity in the home as a basis for borrowing. The proceeds of the loan are then used to pay off high-interest credit card debt. The new loan probably will have a must lower interest rate than the one on credit cards, so monthly repayments are smaller-maintaining the same repayment amount would mean that debt is pay off much sooner.

For example, if you have $15,000 of credit card debt with an interest rate of 15% (rates can be substantially higher) and roll this into a home equity loan at 6%, you’d save $1,500 annually, allowing you to get out of debt more quickly.

Also, the interest on the home loan can be deductible. Points to note:

Borrowing is limited. Generally, you can tap into only about 80% of a home’s equity (the value of the home). Any preexisting debt, such as a mortgage, reduces the amount you can borrow. For example, if a home is worth $250,000 and the homeowner has an outstanding mortgage of $100,000, borrowing will probably be limited to $100,000 ($250,000 × 80% − $100,000 existing debt).

Home is at risk. Switching from credit card debt to home mortgage debt will not necessarily solve a credit problem. If you fail to repay the new debt, you risk losing your home. Just because you’ve reduced your monthly outlays and created a tax deduction does not mean you now can go out and reamass more debt. This may be a financial signal that you need to work with a planner or debt counselor to get your spending habits under control.

Interest is deductible only on limited borrowing. Interest becomes deductible if the debt is secured by the home and the amount of borrowing does not exceed certain limits. If you obtain a home equity loan, which is essentially a second mortgage at a fixed rate of interest, or a home equity line of credit (HELOC), which lets you tap into a set amount on which you pay a fluctuating interest rate, the maximum deduction is capped for borrowing of $100,000. If you borrow $150,000 to pay off credit card debt, this means that only two thirds of the interest payments are deductible. Since the average outstanding credit card debt in the United States is about $9,000, this borrowing limit should not be a problem and all interest will probably be deductible.

Alternative strategy

If you don’t want to put your home at risk but want to get a better handle on debt repayment, consider using a 0% balance transfer. This means moving debt from the current high-interest credit card to one offering zero interest (typically for six months), or at least a low introductory interest rate, for balance transfers. This will reduce the interest cost, allowing for greater payments of principal-actual debt reduction. This strategy can be used repeatedly.