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If you took out a personal loan last year or you’re thinking about getting one this year, you may wonder how that loan will affect your taxes. For instance, is personal loan interest tax deductible? The answer is that a personal loan likely won’t have any effect on your taxes — positive or negative.However, there are exceptions. You may be able to take a personal loan interest deduction if you use the proceeds for certain, specific purposes. Read on to learn which expenses count, plus what other types of loans may be tax deductible.
Is Personal Loan Interest Tax Deductible?
Generally, the answer is no. The reason is that personal loans are typically used to cover personal expenses, such as paying for a home repair, expensive purchase, or consolidating debt, and you generally don’t get to deduct personal expenses.That said, there are specific instances when you can legitimately take personal loan interest deduction at tax time. If, for example, you use the loan proceeds for business expenses, qualified education expenses, or eligible taxable investments, you may be able to deduct the interest on your taxes. If you do not use the loan for one of these reasons, then interest you pay on a personal loan probably isn’t tax deductible.
Types of Personal Loan Interest
Before we go any further, here’s a snapshot of the types of interest you may pay on a personal loan. They can include:
A personal loan with simple interest can be more cost effective for you than one with compound interest or with precomputed interest loans. With the first type, interest is calculated on the principal amount of the loan. With the second, interest is calculated on the principal amount and the interest that’s accumulated. Thus, with compound interest, you’re paying interest on interest. With precomputed interest, the interest is calculated upfront and then added to the principal balance. The interest you pay at the beginning of a precomputed loan is higher than the interest you pay at the end.
Fixed Rate
With a fixed rate personal loan, the interest rate (and your monthly payments) will not change throughout the life of the loan. The good news is that the rate and payment can’t increase, which makes it easier to budget. That said, the interest rate can’t go down, either, which can box you in if the initial interest rate is relatively high. That’s why it’s important to know the average personal loan interest rate and then shop around and compare personal loan rates before choosing a fixed rate loan.
Variable Rate
A variable rate personal loan, meanwhile, has an interest rate that fluctuates based on a benchmark, often the prime rate plus a few percentage points to allow the financial institution to generate profit. The initial interest rate of a variable rate loan usually starts lower than a fixed rate loan, which is a plus, but some borrowers don’t like the uncertainty associated with potential rate increases. For instance, there may be interest rate increases in a recession.
Do I Have to Declare Personal Loan Interest on My Taxes?
In most situations, no. You must declare income on your tax return, and personal loans are typically not considered income, since you have to pay them back.
Does Loan Interest Reduce Your Taxable Income?
Generally, personal loan interest does not lower the amount of your taxable income. However, as we consider the question of when is personal loan interest tax deductible, there are some instances when you may be able to deduct it. For instance, if you are able to use a personal loan for business expenses, you may be able to deduct the interest associated with the expenses. Let’s say you use the loan funds to purchase supplies for your business. In that case, you might be able to deduct the interest from your business’s income, which could help lower your tax bill. However, interest may only be deducted if the purchases you made were business expenses. See below for more information on this.Student loan interest and interest from certain taxable investments may also qualify for deductions. Read on to learn more.
Exceptions to Personal Loan Interest Deduction Rules
You can’t deduct interest on a personal loan, unless you use the funds for one of the following purposes:
Business expenses
Qualified higher education expenses
Taxable investments
Here’s more about each exception.
Business Expenses
Personal loans typically can’t be used for business expenses, but if your lender allows it, the interest on the loan would then be tax-deductible. This can be true even on a freelance or consulting gig. If you use part of the funds for business expenses and part for personal expenses, however, you would need to separate out the interest paid on the portion that went toward business expenses, since only that portion of the interest can be deducted for the year. To benefit from this deduction, it’s important to keep track of how you spend the personal loan funds and make sure you categorize business expenses as you go.
Student Loan Expenses
Most commonly, people take out federal or private student loans to pay for higher education, since student loans often come with repayment plans that fit well with students' needs. And, in some cases, federal student loan borrowers can qualify for forgiveness and hardship programs.However, if you use a personal loan to refinance college loans or pay for qualified educational expenses — such as college tuition and associated fees — it may count as a qualified student loan. As a result, the interest payments on the loan could qualify for the student loan interest deduction.The student loan interest deduction is an above-the-line deduction, which makes it more of an adjustment than a deduction (and, thus, more valuable). And, you can claim it even if you take the standard deduction and don’t itemize your deductions.Recommended: Understanding Personal Loans for Students
Taxable Investments
If you use online personal loans to buy taxable investments, such as certain stocks, bonds, or mutual funds, you may be able to deduct the interest you pay on the loan. This isn’t allowed, however, if you use the loan to buy tax-advantage investments, such as tax-exempt bonds.Even if you only use part of a personal loan to buy taxable investments, you may be able to take a deduction for the interest that corresponds with the amount used to buy these investments. To benefit from this, you’ll need to itemize your deductions, and there are limits to what you can deduct.
Loans that Are Tax Deductible
Though personal loans are typically not tax deductible, here are some other types of loans that are.
Mortgages
The interest you pay on a mortgage is generally tax deductible, provided you use the money to buy, build, or improve a home. While the Tax Cuts and Jobs Act (which went into effect in 2018) created new rules for deducting mortgage interest payments, it didn’t get rid of the deduction altogether. However, if you qualify, you must itemize your deductions to benefit.
Second Mortgages
Interest payments on second mortgages, such as a home equity loan (HEL) or home equity line of credit (HELOC), may be deductible as long as you use the proceeds from the loan to substantially improve the home by increasing its value or extending its life. Using the money to make purely cosmetic changes that don’t increase the home’s value likely wouldn’t qualify for an interest deduction.
Business loans
If you run a business or are self-employed, you may be able to deduct the interest you pay on a business loan you use for business purposes. To qualify for this deduction, you must be liable for the debt, intend to repay the debt, and have a true debtor-credit relationship with the lender.
How Much Loan Interest Can You Deduct on Your Taxes?
While you may only be able to deduct interest from a personal loan if you use it for business expenses, qualified higher educational expenses, and certain taxable investments, mortgage interest is typically tax deductible. You can generally deduct the interest you paid on $750,000 of mortgage debt for your primary residence or a second home. Just be aware that you’ll need to itemize your taxes to take the deduction.Recommended: What Is a Tax Refund Loan?
How Do I Report Interest Paid on a Personal Loan?
In general, you won’t need to report interest paid on a personal loan because the interest isn’t typically tax deductible. If you used the funds for a reason that serves as an exception — such as for qualifying business expenses, student loan costs, or taxable investments — you would follow the IRS guidelines for those types of expenses and/or investments to see if they’re deductible and where to report them on your tax return.
Tips for Reducing Tax on Interest
To help reduce the amount of tax you pay on loan interest, be sure to take any interest deductions you may qualify for. This includes the mortgage interest deduction as well as the student loan interest tax deduction, if it applies to your situation. And don’t forget your business expenses and certain taxable investments if you took out a personal loan to pay for them.Keep good records and make sure you have the proper documentation for any interest deductions you claim on your taxes.
How Does Canceled Personal Loan Debt Affect Your Taxes?
If you don’t repay a personal loan in full and the lender agrees to forgive all or part of the outstanding balance, this creates cancellation of debt (COD) income. Generally, any COD income is considered to be taxable, since it’s money you received and did not pay back. If this applies to your personal loan, you’ll receive an IRS Form 1099-C from the lender that lists how much COD income you must claim on your tax return.
The Takeaway
A personal loan can provide you with funds to make a large purchase, pay for an emergency, or consolidate debt. And, in most cases, personal loans won’t have any effect on your taxes.There are some situations, however, where you may be able to deduct the interest you pay on a personal loan. This includes when you use the loan proceeds to pay for qualifying business or education expenses or when the funds are invested in taxable vehicles.Because you typically can’t deduct personal loan interest, it can be smart to minimize how much interest you pay on the loan in the first place. To find a good rate, it often pays to shop around. With Lantern by SoFi, you can compare personal loan offers from multiple lenders in just a few minutes and with only one application.
Frequently Asked Questions
How do I report interest paid on a personal loan?
Do I have to declare a personal loan on my taxes?
How does canceled personal loan debt affect your taxes?
How much loan interest can I deduct?
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About the Author
Kelly Boyer Sagert
Kelly Boyer Sagert is an Emmy Award-nominated writer with decades of professional writing experience. As she was getting her writing career off the ground, she spent several years working at a savings and loan institution, working in the following departments: savings, loans, IRAs, and auditing. She has published thousands of pieces online and in print.
