Today President Donald Trump signed the Republican tax reform bill into law. The new bill makes a number of significant changes to the tax code, including doing away with the deduction for the interest paid on home equity loans. Here is what you need to know about that change.
What are home equity loans?
These are loans that can be taken out by homeowners using their home equity. Home equity is the difference between a home’s market value and the remaining balance on the mortgage. Homeowners have two options: they can take out a home equity loan, which is a one time loan with a fixed interest rate, or they can take out a home equity line of credit, which acts like a credit card with a specific debt limit based on home equity. The interest rate on a home equity line of credit varies with the market.
How does the tax reform bill affect the home equity loan market?
In the past, homeowners who took out home equity loans were able to deduct the loan’s interest up to $100,000 from their taxes. Under the new tax bill, this deduction is a thing of past. The change takes effect in 2018, meaning this is the last year that homeowners can write off the interest paid.
"There is no grandfathering,” points out Greg McBride, chief financial analyst at Bankrate.com. “A lot of people may think: ‘I'm glad I got mine already.’ Nuh-uh. You're going to get hit by this just as much.”
How big is the home equity loan market?
According to the most recent numbers from the New York Fed on America’s debt, balance on home equity lines of credit came in at $448 billion at the beginning of this year.
The home equity loan market has changed over the years. According to the New York Fed, home equity borrowing amounted to an average of $181 billion a year from 2000 to 2003. Whereas during the recovery from the Great Recession, from 2012 to 2015, it dropped to an average of just $21 billion a year.
“A lot of homeowners couldn't even take home equity loans because they didn't have enough equity and they've been resorting to personal loans,” McBride said.
He is not the only one who noticed. In a speech earlier this year, William Dudley, president of the New York Fed, said: "The previous behavior of using housing debt to finance other kinds of consumption seems to have completely disappeared. People are apparently leaving the wealth generated by rising home prices 'locked up' in their homes."
In the past, people would take out home equity loans to make renovations (45 percent), pay off their debts (26 percent), buy a car (9 percent), or pay for medical emergency/tuition (4 percent), according to a 2007 U.S. Census report.
So what happens now that the interest is not tax deductible?
A couple of things:
1. Even fewer people might take out home equity loans. They will still invest in their homes — just with a different financing options, according to McBride.
“In terms of things like home improvements, people are still investing in their homes,” he explained. “Consumers have not warmed to the stock market but consumers continue to invest in their own homes. And even if one avenue of borrowing is not as attractive as it used to be, it's not going to change the tendency of homeowners to invest in their own homes. Instead of taking out a home equity line of credit, they may just do a cash out mortgage refinance.”
2. More people might try to pay down their home equity loan faster.
“It will change the prioritizing of debt repayment,” McBride said. “There's going to be a greater incentive now for people to pay down that home equity line because they're not getting a tax deduction and interest rates are rising. So the net cost of that debt is rising quickly. So people have an incentive to pay it down.”