Should Clients Refinance Debt With

a HEL?

Spreadsheet programs are one of the more sophisticated tools available for accountants to use in personal financial planning for clients. Applications using spreadsheet analysis are especially useful in situations where alternative scenarios need to be compared over longer periods. This article provides examples of electronic spreadsheets applications in analyzing alternative loan proposals and using home equity loans to refinance personal debt.

Home Equity Loans (HELs)

TRA 86 phases out the deductibility of interest on personal debt by 1991. During 1988, 40% of the interest on personal debt was allowed as an itemized deduction. This is reduced to 20% in 1989, 10% in 1990 and 0% in 1991 and future tax years. There are also proposals to accelerate the phase out.

While HELs have been available for a number of years, they have recently emerged as a major means of raising personal capital. Under TRA 86 HELs have become one of the few means of borrowing up to $100,000 for consumption purposes with the interest fully deductible on the income tax return (subject to the acquisition indebtedness limit of $1,000,000). If the mortgage balance plus the HEL do not exceed the fair market value of the home, the interest charge on the HEL is fully deductible as mortgage interest. Also, interest on HELs used to pay for medical expenses or education expenses are fully deductible regardless of the equity position in the home.

An Example. If a client has significant personal interest bearing debt and adequate equity in his or her home, using that home equity to liquidate the personal debt will usually make sense. A spreadsheet program is an easy way to calculate savings for the client. Variables to consider include:

* The amount of debt;

* The amount of equity;

* The repayment period;

* The rate of interest on debt equity;

* The use of the HEL funds; and

* The tax position of the client.

Assume the client has a home with a fair market value of $200,000, a mortgage balance of $115,000, and personal debt of $35,000 (for the purpose of an auto, payment of uninsured medical bills, purchase of clothes, travel, etc.). Assume the personal debt schedule for the client, as of January 1, 1989, was as shown in Table 1.

Building an amortization schedule using a spreadsheet program such as Lotus 1-2-3 is fairly easy. If the client is making monthly payments to amortize the debt over the remaining periods, principal and interest during 1989 and 1990 would be $1,117.57 a month, or $13,410.84 for each year. Table 2 shows the annual amounts of payments, principal, and interest paid on each obligation for each of the remaining years. The monthly amortization of each loan, of which Table 1 is a summary, is not presented.

While the total annual payments would be $13,410.84 for the first two years, part of the payment is still tax deductible. Toal interest paid in 1989 would be $5,641.74 and 20% ($1,128.35) can be included as an itemized deduction. If the client is in the 28% marginal tax bracket for federal income taxes, this itemized deduction will reduce his tax liability by $315.94 (state tax rates should be included as applicable). For 1990, total payments will still be $13,410.84, but the interest portion will be $4,011.12, 10%, or $401.11, of which will be deductible. Assuming the 28% marginal tax rate, the tax liability will decrease by $112.31. The tax savings for each year are shown in Table 3.

For most who itemize their deductions, the loss of deductibility of interest payments has a significant negative effect on cash flow.

Conceivably, the client could borrow up to $85,000 against the equity in his or her home ($200,000 less the mortgage balance of $115,000) fo refinancing the personal debt. Lenders normally would not advance more than the fair market value of the home, less the amount of the mortgage balance, less a safety amount (conservative lenders might lend 80% of fair market value). Using that as an assumption, the amount the client could borrow as a HEL would be $45,000 ($200,000 x 80%)-$115,000. Assuming the client only wanted to refinance personal debt, then a $35,000 HEL would be reasonable.

Which Mortgage Company?

Will the client be better off economically if a HEL is used to satisfy the personal debt? The most realistic method of evaluating the question is to look at the present value of the current situation versus the present value of the alternatives. Using an electronic spreadsheet, all of these amounts can be computed easily.

First, which lender should be used? Impotant considerations that the client must weigh in the decision include the cost of obtaining the HEL in fees or points, the interest rate, and the repayment period. For example, assume the client has two different institutions willing to make the loan, with different charges and interest rates. See Table 4.

Many institutions include the financing expenses in the amount of the loan, which increases the principal and the payments. In this example, the up-front expenses would be $1,050 ($35,000 x 3%) for institution A and $950 ($35,000 x 2%) + $250 for institution B. The application fee and miscellaneous expenses are normally not tax deductible. The points, however, are amortized and deducted as interest expense over the life of the loan. Amortization schedules for these two loans are included in Table 5, assuming the loan expenses are paid in advance and the discount points are amortized as part of the interest expense over the life of the loan.

For a direct comparison, it is assumed the client elects to repay the HEL over the same five-year period it will take to repay the personal debt. Table 6 shows, for each institution, the net after-tax cost for each year and the total for the five years, assuming the client is in the 28% marginal tax bracket. Interest on HELs is fully deductible.

While the payments are higher from institution B, more of the payment goes to interest, resulting in a larger tax deduction. The after tax interest cost, however, is still higher from institution B ($10,088 compared to $9,639) as is the after tax total payment over the life of the loan ($45,088 compared to $44,639). In this case, the client is better off going to institution A and paying a larger amount of points but getting a lower interest rate. With different institutions, the interchange between points and interest rates can be compared using the spreadsheet analysis developed above.

Should Your Client Refinance?

The client can now be effectively advised about the advantages and disadvantages of converting personal debt to mortgage debt through a HEL. Table 7 shows the comparison of the cash flows with a HEL from institution A (Table 6) and from keeping his or her current debt portfolio (Table 3). While paying only slightly less in total payments ($48,388 compared to $48,860), the tax deductibility of the HEL makes the net of tax payments much more attractive ($44,639 compared to $48,432).

The cash flow advantage of the HEL over the current personal debt package is $3,793 over the five years. Computing the present value of the savings from the HEL financing shows an even more significant difference because of the timing difference in the cash flows. The present value of the savings is $4,613 with a 10% discount rate, a significant savings for the client.