No matter how often you change the oil, flush the radiator or replace the hoses and belts, eventually your ride will go to car heaven – or an owner more patient with hassles. With new car prices averaging around $30,000, you may have to borrow to stay on the road.
If you’ve owned a home long enough to build up some equity, you have a choice: a car or home-equity loan. Deciding which is best involves more than comparing interest rates. On close examination, many car buyers might find a home equity loan is better today, especially if they are willing to take some risk with a floating-rate line of credit rather than a fixed-rate installment loan.
Today, the average five-year new car loan charges about 5%, according to the BankingMyWay.com survey, while the average five-year home-equity installment loan comes to around 7.3%.
At first glance, the car loan appears to be a better deal, but it really depends on your tax bracket. Most homeowners can deduct mortgage interest payments on their federal tax returns, and that includes interest on home equity loans. A car loan, whether from a bank or dealer, is not deductible.
So how do you compare the two types of loans?
The easiest way is to convert the home equity loan to a taxable-equivalent interest rate. At 7.3%, every $100 you borrow costs $7.30 a year. But the tax deduction on that $7.30 reduces your tax bill, so you’re not paying much.
Start with the number one, subtract your tax bracket, then multiply the loan rate by the result. If you’re in the top, that is, the 35% tax bracket, subtract 0.35 from one to get 0.65. Then multiply 7.3% by 0.65 to get 4.75%. In other words, once the tax deduction is taken into account, you’ll pay $4.75 a year for every $100 borrowed, compared to $5 for the car loan. As a result, the home equity loan is a slightly better deal.
However, if you’re in the 15% tax bracket, as the tax deduction on the home equity loan won’t be as valuable. It reduces the 7.3% rate to 6.2%, so you’ll do better with the auto loan.
Now, consider the third option: a home equity line of credit or HELOC. It carries a floating rate, while the installment loan’s rate is fixed. Many HELOCs now start around 3.75%, and some are even lower than that. But because that rate may last for only a few months, consider what you might pay in the future.
A borrower with good credit can expect HELOC with monthly adjustments that go to about two percentage points over the prime rate, currently 3.25%, for a rate of 5.25%.
For a taxpayer in the 35% bracket, this comes to 3.4% on an after-tax basis. Even a taxpayer in the 15% bracket would come out ahead, paying just under 4.5% with the deduction counted, compared to 5% on the new-car loan.
With the HELOC, you would have to pay in the future if the prime rate rises. At the moment that risk doesn’t seem very serious, as the Federal Reserve has just reaffirmed its plan to keep interest rates low for some time.
Still, it probably makes sense to fund a car purchase with a HELOC only if you had the resources to pay the loan off quickly if interest rates jumped.
With any of these loans, be sure to look at fees as well as the interest rate, as they could easily tip the balance on a close call. Shop for good deals with the Home Equity Rate Search tool and the Auto Loans Rate Search tool.
—For more ways to save, spend, invest and borrow, visit MainStreet.com.