Using home equity to buy a car

Dear Dr. Don,
My husband and I are looking to buy a new vehicle. As we consider our different options for auto financing, we wonder if we could tap into our home's equity to buy the new vehicle. We own a home in South Florida and have seen our home's value rapidly increase over the past few years. Is it possible to use a home equity product to buy a car? If so, is this a wise move, or are we better off leaving our home's equity alone?
-- Dani Driver

Dear Dani,
A home equity loan is a fixed-rate, fixed-term, self-amortizing second mortgage. You won't have to worry about the interest rate increasing over the loan term, and the monthly payments contain both a principal and interest component, forcing you to pay down the loan balance over time. You have some choice over the loan term, but if you're using the proceeds to buy a car, you would want the loan term to be shorter than the expected useful life of the automobile.

A home equity line of credit, often called a HELOC, is also a second mortgage, but it has a variable interest rate pegged to a short-term interest rate and the interest rate on the loan will fluctuate with changes in that short-term interest rate. These loans are typically priced based on the prime rate of interest, which you can track using Bankrate's Rate Watch. If you have good credit the variable rate on the HELOC should be within a quarter percentage point of the prime rate. The variable rate loan may have a minimum interest rate (floor) and a maximum rate (ceiling) over the term of the loan.

In the early years of a HELOC, the monthly payment typically just covers the interest expense. After a set time period, say 10 years, the loan payment may change to be self-amortizing over the remaining loan term. If not structured this way, the borrower could wind up with a large balloon payment at the end of the loan term.

Since a HELOC is a line of credit, the borrower can repay the line and turn around and draw against the line again. This could work well if you and your spouse own two cars and alternate replacement vehicles over time. A HELOC can also act to supplement an emergency fund when working through a short-term financial crisis.

The interest expense on mortgage debt may be deductible on your income tax return. If so, it reduces your effective cost of debt. The IRS Web site has more information on the tax deductibility of mortgage interest expense. The interest expense on an auto loan isn't tax-deductible.

With auto loans, low interest dealer financing often comes at the expense of reduced negotiating power over the price of the car. Bankrate has a calculator that helps you decide between accepting a rebate and taking the low interest financing on the car.

The closing costs on a second mortgage are significantly less than a first mortgage, which makes a cash-out refinancing of a first mortgage an unlikely approach to auto financing unless the refinancing can be justified on a stand-alone basis for the existing first mortgage and there's enough equity to allow the homeowner to get enough cash out to buy the car while avoiding private mortgage insurance. Still, closing costs on a second mortgage are a consideration when trying to decide whether it's the right approach to financing the vehicle.

Taking 10 years to pay off a car that you'll only own for six doesn't make much sense. Making interest-only payments on a HELOC as your car depreciates in value doesn't make much sense. Watching short-term interest rates climb higher on your HELOC when you could have locked in a fixed-rate home equity loan doesn't make much sense.

If you need to finance a vehicle, you should choose the option that minimizes your effective interest expense. The tax deductibility benefits of a second mortgage to finance a car could be completely offset by the closing costs on that loan. I've put together an example in the following table:

The middle scenario reflects the monthly payment on a 10-year home equity loan plus the difference between that payment and the conventional auto loan payment as an additional principal payment each month. One way or another, you need to consider the cash flow differential between a 10-year mortgage loan and a five-year auto loan.

The easiest way to make them more readily comparable is to equate the monthly payment by making additional principal payments and seeing how that shortens up the loan term. In this case, it shortens the loan term on the home equity loan to 59 months, or within a month of the auto loan. The closing cost was just a guesstimate, but the estimated value of the tax deduction was 25 percent of the total interest expense of the mortgage loan, reducing the effective interest expense.

What's the bottom line from all of this? Construct your own table by using Bankrate's auto loan calculator with amortization schedule, your estimated loan amount and your marginal federal income tax rate replacing the 25 percent in my example.

What I hope you get from this lengthy discussion is the idea that to end up spending less money in total financing costs, you need the financial discipline to make additional principal payments along with the monthly home equity loan payment. With that approach, you may be able to save some money when financing your next car. Using the home equity loan exclusively to reduce your monthly car payments has you paying thousands of dollars more in interest expense.