Q: I have several credit-card debts and a lot of equity in my home. In my last meeting with my financial adviser he suggested that I refinance my home and take the cash to invest in the stock market. His rationale was that I’d have a deductible mortgage interest at a low rate and be able to earn a higher rate of return in the market. I’m not sure I want to invest more money in the stock market, but I’m thinking his plan may make sense if I take enough cash from a refinance to pay off my credit-card balances, which rose to $30,000 while helping with my son’s college expenses (he graduated in December and even has a job). The credit cards are charging me 9 percent and I’m paying around $620 a month toward this debt. I think I can get a 30-year mortgage for 4.5 percent with just a few points. The points paid will be deductible and with my mortgage interest tax deduction the rate I’m paying will be less than 3.5 percent. Seems like a no-brainer to me. What am I missing?
Congratulations on your son’s graduation and on obtaining employment! In a worst-case scenario, if you fail to make your new higher payments on your home mortgage, the bank or lender can seize your home. Failing to make your credit-card payments is bad, but you won’t have your home at risk. With that said, if you can trade a 9 percent interest rate for one under 5 percent, your monthly overall cash out-flow will be much lower so you should not have a problem paying the higher mortgage. An additional $30,000 will increase your monthly payments by $151.
All of the interest should be tax-deductible. I say “should” because the IRS distinguishes between acquisition indebtedness and home-equity indebtedness to determine if your mortgage interest is deductible. Debt incurred to acquire, construct or substantially improve your home is tax deductible. Indebtedness is reduced as the debt is paid off and cannot be increased by refinancing. Refinancing of an acquisition debt is considered acquisition debt to the extent it does not exceed the principal outstanding on the loan immediately before the refinancing. Debt secured by the home which exceeds the acquisition indebtedness is deemed home-equity indebtedness and is limited to the lesser of fair market value of the home minus total acquisition indebtedness on that home or $100,000 ($50,000 Married Filing Single), whichever is less.
Acquisition and home equity debt may be combined in a single loan when claiming interest deductions. Refinanced debt amounts in excess of the prior debt’s outstanding balance can be combined in a single loan.
You may want to inquire about a home-equity loan versus refinancing. Rates are similar and the fees to initiate a home-equity loan are minimal. If you continue to pay $620 per month toward your credit card at 9 percent it will take about 5 years to pay off your current balance. If you can get a 5 percent home-equity loan to pay off the credit card and make the same payment on the loan, you will have the loan paid off in 4.5 years. This would save you $3,720.
Whether you decide to refinance or get a home-equity loan be aware that interest on home-equity money is not deductible for Alternative Minimum Tax purposes. This probably doesn’t apply to you since it sounds like you acquired your credit-card debt for the worthy cause of helping your son through college, but I’ve seen too many instances where people use equity in their home to pay off consumer debt only to find themselves accumulating more consumer debt. Now, in addition to a credit card balance, they owe more on their homes.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 99466, Raleigh, NC 27624