In all likelihood, you have seen advertisements telling you to use your home equity to pay for college tuition or buy a big-ticket item like a boat or a car. These loans can be a very tempting way to go. But you should make sure you understand the pros and cons involved with using a home equity loan rather than a traditional car loan to buy your next car.
What is a home equity loan?Your home equity is the difference between the value of your home and the amount of the mortgage. Lenders will typically lend up to 90% of your home's value. Under this scenario, if you own a home appraised at $150,000, the maximum your lender will loan you is $135,000. If you only owe $100,000, you could qualify for a $35,000 home equity loan.
A home equity loan is a second mortgage on your home.
Lending guidelines vary widely by lender. Some lenders will only loan up to 80% of the appraised value of the home while others may lend as much as 125% of the appraised value. Closing costs can also vary by lender. Depending on the program offered, you could pay hundreds of dollars in fees to close your home equity loan. Other lenders offer no closing cost loans. This can be a deciding factor for many when choosing between a home equity loan and a car loan.
1. Interest Rate
The interest rate on a home equity loan is generally lower than that of a traditional car loan. A home equity line rather than a loan usually carries even a lower rate. Because of this, you can save hundreds if not thousands of dollars over the life of the loan.
Because a home equity loan is tied to your home, all interest paid on loans associated with it (up to $100,000) is considered mortgage interest and is deductible on your income taxes. It does not matter how the money is used. Of course, this is only a benefit to you if you are able to itemize on your income taxes. Interest paid on a traditional auto loan is not deductible. For many people, this is the biggest draw to using a home equity loan to buy a car.
Keep in mind, the IRS will only allow you to deduct interest on loans that do not exceed the total value of your home. If you have a $125,000 home with a $110,000 mortgage, you would only be able to deduct interest for the first $15,000 in home equity debt.
1. You are risking your home
By financing your car through a home equity loan rather than a traditional auto loan, you are putting your home at risk. If you are unable to make your car payments, you now not only risk losing your car but also your home.
2. Less cushion if the real estate market takes a turn for the worst
Another risk, though not as common, is the possibility of your home losing its value. In the majority of cases, real estate appreciates as time goes on making your investment better and better in the long run. But there have been cases where the market has taken a nose-dive and property values have followed. In this scenario, if you sold your home and owed more than you received, you could end up having to take out an additional loan to be paid long after you moved out of your home.
3. Using your equity when there are other sources
If something disastrous happened and you needed access to a large sum of money such as a major home repair or medical expenses, home equity is usually the least expensive source of money. But if you have maxed out your home's equity by buying a car, this option may not be available to you.
Your home's equity is a valuable asset that should be used wisely. With many dealers offering zero percent or a low interest car loan, you should definitely look at all of your options before cashing in your home's equity.