Would you take out a 30-year car loan? How about a 10-year auto loan?
If you're going to finance the a car with the equity in your home, that is exactly what you could be doing -- paying for a car over 10 or even 30 years.
The use of home equity loans, lines of credit, and cash-out refinancing to buy a vehicle grew in the last decade as interest rates dropped and property values soared. It also has become popular as lenders hyped the fact that interest on a home loan is tax-deductible, unlike a car loan.
In 2006, about 24 percent of homeowners used a home equity line of credit to purchase a vehicle, according to Synergistics Research Corp., a financial services consumer market research company in Atlanta. About 8 percent of homeowners took out a second mortgage specifically to buy a vehicle, says William H. McCracken, chief executive of Synergistics.
But is buying a car or paying off your remaining auto loan balance with the borrowed equity from your home a good financial move?
"I issue a note of caution on this," says Don Taylor, a columnist for Bankrate.com and an associate professor of finance at The American College in Bryn Mawr, Pa. "If you don't have the discipline to do more than the minimum payments on these loans, then this is not a good idea."
The assumption people make is that the home equity loan is cheaper than a traditional car loan because of the mortgage interest tax break. However, if you don't make extra payments or pay the loan off early, you end up paying more in interest over the life of that loan than you would with an auto loan, erasing any savings on your taxes. Plus, because the car money is rolled up in a home mortgage, you could still be paying on a loan for a vehicle you've long since sold or traded in.
I asked Taylor to run a few financing scenarios to compare the total cost of four types of auto borrowing -- a 60-month car loan, a 10-year home equity loan, a 10-year home equity line of credit, and a 30-year cash-out mortgage refinance. To view the full results or to plug in your own loan figures, income tax rate and interest rates, go to bankrate.com/compare.
So let's look at one example of an auto loan versus a home equity loan in which you finance $30,000. If you took out a five-year car loan at 7.76 percent (the national average, according to Bankrate.com), your monthly payment would be $604.85. Over the 60 months of the loan you would pay $6,291.11 in interest.
If you took out a 10-year home equity loan for $30,000 at 7.88 percent, your monthly payments would be significantly lower at $362.08, Taylor calculated. Make extra payments of $242.77 during the first 60 months and you'd pay $6,417.71 in interest. If your federal marginal income tax rate is 25 percent, your effective interest rate on the home equity loan is 5.91 percent. Thus you would save $1,356.03 in interest in today's dollars (not including estimated loan costs of $500).
However, if you don't itemize your taxes to get the interest deduction and you fail to make extra payments every month, you end up paying $13,450 in interest, a difference of $7,158.89, according to Taylor's calculations. Under that scenario, and even with the tax deduction, the auto loan is cheaper.
The savings are even less with a home equity line of credit versus a home equity loan. That's because the interest rate for a line of credit is higher. The average interest rate on a home equity line of credit is 8.13 percent. If you take the interest deduction, your effective rate would be 6.10 percent. But again, to make it worth the trouble, you still have to make extra payments. Even with the interest tax deduction, auto loan rates may be better if you have good credit and shop around.
Considering a 30-year cash-out refinancing to buy a car or pay off an auto loan? With rates at about 6.2 percent, your effective interest rate if you itemized would be 4.65 percent. But don't forget that with a refinance you have to factor in closing costs, which average about $3,000, according to Bankrate.com. Of course, you wouldn't allocate all the closing cost to the car loan, Taylor points out, but you still have to consider that expense to determine if you're really saving money.
"For you to do a cash-out refinancing it has to make sense on its own, such as you are getting a lower interest rate," Taylor said. "Buying a new car on its own isn't a reason to refinance your first mortgage."