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Someone posted a formula a while back for calculating the effective rate of a home equity line factoring in the tax deduction. Can someone point me to the post or give me the formula? I have a home equity line at 9.25% which I can deduct the interest on. I also have a personal loan at 8.25% and was considering transferring the personal loan balance to the equity line...


HEQ: $64,252.75 (currently paying $1000.00/mo)
Personal: $11,686.41 (currently paying $244.00/mo)

Of course I would add the $244.00 to the $1000.00 if I do the transfer...

This is my only debt.

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Assuming that you can and are deducting the entire interest on your home equity line of credit, and all your other itemized deductions combined equal or exceed your standard deduction, the forumula is:

After_Tax_Rate = Before_Tax_Rate * (1.0 - Marginal_Tax_Rate)

For example, if you are in the 28% marginal tax rate, and the home equity line of credit has an interest rate of 9.25%APR, the numbers work out to:

After_Tax_Rate = 9.25% * (1.0 - 0.28)

After_Tax_Rate = 9.25% * 0.72

After_Tax_Rate = 6.66%

It rapidly becomes more complicated if you have state income tax and you can deduct your home equity interest on your state returns as well as your federal returns because of the interaction of state taxes on federal returns. For example, I am in the 28% federal marginal tax rate and 9% Oregon state marginal tax rate, for a combined marginal tax rate of about 34% (not 37%) because the decrease in state taxes increases the federal tax obligation, e.g., 28% federal + 9% state - 28% * 0.09 (to reflect increased federal tax for state tax reduction) = 34.48%.

Now after supplying above, don't forget the human factors:

1. There is a tendency to think of the refinanced debt as eliminated debt--it isn't, it is just moved.

2. Many people tend to get back into unsecured debt because they feel a false sense of relief, with the resulting situation worse than before--less home equity and now back up to high levels of credit, but this time without additional home equity to tap into.

3. Worse yet, it is now secured so one has to make even larger monthly payments or the house is at more risk. Because the obligated payments are larger on the secured debt, one can view the house as being at more risk. (While the debt was unsecured, creditors could make your life miserable and get a judgement to garnish wages, but they couldn't take your house. But with the loan specifically secured by your house the house can be taken away after enough missed payments.)

4. Just because the effective after-tax interest rate is less, it does not necessarily follow that one will be paying fewer dollars toward that debt--if one is taking longer to pay off that part of the debt one could end up paying more dollars toward the interest than when one had the pressure to pay off the loan as soon as possible. A Foolish approach (Big F = Good) would be to make use of the lower after-tax interest rate to pay off the loan faster by having more of each payment go towards the principal instead of interest than before.
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