The use of home-equity loans, lines of credit and cash-out refinancing to buy an automobile grew in the past 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 on a vehicle loan.
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 Don Taylor, an associate professor of finance at The American College in Bryn Mawr, Pa., 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. For more information, 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, your monthly payment would be $604.85. Over 60 months, 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. 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, you may find better auto loan rates if you have a good credit history and shop around.
Considering a 30-year cash-out refinancing to buy a car or pay off the balance on 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.
