Question: My wife and I are considering refinancing our home with a rare type of loan that looks quite interesting. This loan is called a “First Trust Deed, Home Equity Line of Credit” (FTDHELOC). Our current loan is a traditional 15 year mortgage at 4.875%, with 13 years left on it.

The FTDHELOC is a very common type of home loan instrument in Australia, New Zealand, and South Africa, but it seems to be quite rare here in the U.S. (HELOC’s as seconds are common, however.)

How it works is that the home is refinanced with a HELOC as the first (and only) home loan, typically up to 80% of the appraised value of the home. The loan is simple interest payback, so that requires strong financial discipline to pay down the principle. Since we are financially disciplined, and budget our monthly house payment, that’s not an issue for us. This type of loan gives us greater cash flow capability to make it through rough times (which we hope never come), and makes it easier to facilitate quicker principle paydown by leveraging the 30-45 day credit card float which we’d use to pay all our budgeted expenses. (Our paychecks are deposited into the HELOC, reducing the loan principle and thus the monthly interest, then we pay all bills and household expenses using VISA, then pay off the VISA *in full* from the HELOC 30-45 days later. The net effect is to drop the average principle of the HELOC by the amount of our monthly income, which has the effect of reducing interest thus meaning more of our budgeted home loan payment will go towards principle and less towards interest. We figure that with this program we’ll reduce the time to payoff from the current 13 years to about 8 years using the same house loan payment, assuming interest rates don’t rise too much — the FTDHELOC has a variable rate, reassessed yearly based on prime, and can never rise more than 5 points above the value when the loan was started, and no more than 1% rise per year.)

I have two questions regarding this type of loan:

1) Are there some hidden “gotchas” with this type of loan? (besides the need to be extremely financially disciplined, which as I noted above we are.)

2) What is the deductibility (Schedule A) of the interest we pay on this loan?

Regarding the tax deductibility, the lender has told us one thing (as I will describe below) which appears to be different from what the IRS says in its publication on home mortgage interest deduction, and what has been mentioned on various newsgroups by tax experts. But then this whole issue is very confusing, and I’m not sure if even CPAs even fully agree on the formula.

What the lender has told us is that the interest on the loan principle up to the *original* home value when first bought is fully deductible, and any interest paid above that amount is not.

For example, let’s say we bought our house at $162,000, the home is now appraised at $250,000, and our FTDHELOC is at $195,000, which becomes our first and only home loan. The simple interest rate is 5% (which is variable, tied to the prime rate with a cap, a downside to the FTDHELOC program.) The lender’s advice is that the interest on the loan principle up to $162,000 is fully deductible, while any interest paid for principle above that amount cannot be deducted.

Anyway, using this same example (I’ll supply more information if that is needed), what interest can we deduct from this loan? (The IRS publication, and the prior discussion on Usenet, is quite confusing on this matter — some advice seems to apply that for the example above only a small amount of the interest will be deductible.) Please post your reply to this newsgroup.

Answer: I currently have a 30 yr mortgage with Washington Mutual Home Loans. They recently offered to refinance with no application fee or closing costs, but I did not get full details because interest rates were not quite as good as I thought I could get.

Shortly after that I got an offer from a local WaMu Bank for better interest, but $295-500 closing costs. It turns out the refinancing is a fixed 20 yr HELOC instead of a mortgage, but for $30 extra per month, it would chop 7 yrs of payments and $62,000 in interest from my current mortgage. Auto Pay would use my own account for payments and escrow and they would direct withdraw the payments (I believe I would pay tax/insurance from escrow in the account myself). I applied, but just have pre-application examples of closing papers.

A 15 yr mortgage at current rates would cost over $100/mo more and would not come out ahead until 17 yrs from now (depending upon how my 401K and IRAs do).

In my case, there would be no question about interest deduction, since it refinances existing mortgage balance on primary residence. But if you used a Visa card from a HELOC for purposes other than home improvement, there may be some question whether that portion of the interest would be deductable. If I did draw any additional at fixed or variable interest, it would be accounted for separately.

But current teaser rates from credit cards are better than a home equity loan for other expenses. I got 0% from Circuit City for a new HDTV and camera, and used 2.99% for unlimited period on another card to pay off higher interest credit cards. But watch out for balance transfer fees on short term teaser rates.

Which brings to light one other thing about HELOCs. Make sure you know if you are getting an initial “promotional” rate that will jack up when it expires (maybe in less than a year).

Related posts:

1. Trust deed back refinancing: is this a legitimate form of investment?
2. Calculation of interest portion of mortgage payments
3. Canadian real estate purchasing strategy to deduct interest costs
4. use my home equity, cash, or mortgage loan or all of the above
5. Do you just have to trust your realtor???
6. Bank One Refinance Question (is interest deductible?)
7. quit claim deed in regards to refinancing
8. refinancing at a higher interest rate?
9. ARM & negative amortization
10. need advice re:quit claim deed
11. Should we end the mortgage interest deduction?
12. Sleazy banks given gift by rats in Washington,DC