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If you’ve been thinking of buying a new or a used car lately, you’ve probably encountered several unpleasant facts about the state of the car market.
Buying a car has gotten expensive due to inflation, high financing rates, rising prices, manufacturing and repair supply chain issues, and pent up demand for cars and trucks by people who put off major purchases during the Covid pandemic.
That’s led people to try and find creative ways to bring down the costs of buying a vehicle, and one of the ways where there might be a way to reduce costs is by looking at alternatives to finance an automobile purchase.
A traditional car loan isn’t your only option. Because homeowners have seen solid appreciation in their home values in recent years, many are asking if they should tap into this accumulated home equity to finance a vehicle purchase.
On the surface, this may seem reasonable, but there are pros and cons you should consider if this is an option you are weighing.
Home Equity Loans and HELOCs
You could use two types of home equity to finance a car. You should be familiar which each one before deciding if these funds are appropriate for this type of use.
Home equity loans provide borrowers with a one-time lump sum. These are fixed-rate loans with a set repayment term, much like a conventional mortgage. You make regular, fixed monthly payments that include both principal and interest over a certain period ranging from five to 15 years.
A HELOC is a home equity line of credit. Think of it as a revolving credit card that you can draw on up to the available balance whenever you need it and for whatever purpose you choose. You pay back loans on the HELOC and can use it over and over up to your approved credit line.
The Pros of Using Home Equity to Buy a Car
Negotiating Power.
When you walk into a dealership after you’ve been approved for a home equity loan or HELOC, you’re essentially walking in with cash in hand. That gives you more bargaining power because financing has already been worked out, removing a major barrier that could impede a car sale. If you pay cash, you could also be in line for certain dealer incentives with a new car purchase.
A longer payback period.
Home equity loans are the equivalent of second mortgages and can be financed over 15 years. This gives you added flexibility if your income varies or you have other debt obligations that could impact your personal finances from time to time. Most HELOCs require that you pay only interest during the first 10 to 15 years of the loan so the amount of principal you contribute is in your control. When you have extra money, you can pay down the principal early, shortening the loan length and reducing your total payments.
Possibly lower interest rates.
Market conditions and financing options have continued to swirl in recent years due to several economic factors. At times, the cost of home equity financing came with much lower interest rates than car loans. The smartest thing you can do is compare the two when you’re ready to buy to see if each option is competitively positioned or if there is an obvious gap that could impact your decision. Be aware that home equity loans are fixed-rate loans, but HELOC loans usually have flexible interest rates depending on economic factors.
Flexibility in how you use funds.
If you take out a home equity loan or HELOC, you don’t need to use all the money to buy a car. With a larger amount in hand, you can use a portion for other things such as home improvements, paying medical bills, college expenses, or other similar big-ticket items. If you put some of the funds into home improvements, you’re investing in an appreciating asset, and this can help offset the costs associated with buying a car, which is a depreciating asset.
Also, consider that you might be able to deduct the interest on what you spend for home improvements if you itemize on your tax return, giving you more money in your pocket over the longer term.
The Cons of Using Home Equity to Buy a Car
While there are several advantages to using home equity to buy a car, there are also several downsides.
Putting your home at risk.
Home equity financing means you’re putting your home up for collateral against these types of loans. If you fall behind or can’t make payments, a bank could foreclose on your property, creating a horrible situation that could impact you for years. With a car loan, you risk your vehicle as collateral; in the worst-case scenario, you could lose it instead. That’s not ideal, but less of a problem than losing your home.
Decreased home equity.
With a home equity loan, you are lessening some of your ownership stake. Levering funds to buy a car means you can use your home equity for other purposes, which could put you in a bind in an emergency. You may also miscalculate your ability to pay and discover you’ve taken on too much home debt. If you eventually sell your home, any home equity loans must be repaid in full, meaning you’ll see less bottom-line profit.
A longer repayment timeline equals higher overall interest expenses.
While your monthly payments may be lower, when you extend payments out for several years using home equity financing you’ll pay more interest in the long run. If you choose a traditional car loan with a shorter repayment period, you will pay significantly less interest on the vehicle.
Home equity loan and HELOC interest deductions are limited.
Before 2017, you could deduct interest no matter what you used loan proceeds for, but that changed with the Tax Cuts and Jobs Act of 2017. Since it was enacted, you can only deduct the interest if the loan is used towards improving, repairing, or buying a home.
The application process.
Applying for home equity financing is much more onerous than applying for a car loan. You’re basically taking out a second mortgage, and if you’ve ever been through the home loan application process, you know how challenging and comprehensive that process is. Plus, you could wait several weeks for approval vs. a car loan which you could be approved for in a day or so.
Closing costs.
You might need to ante up closing costs on a home equity loan, which can run from 2% to 5% of what you borrow. That often gets buried in loan paperwork but don’t let that added cost go unnoticed. Conversely, there are no closing costs with an auto loan.
Investing in a depreciating asset.
New cars lose 20% of their value in the first year of ownership and as much as 60% over the first five years. With home equity financing, you could be paying on your vehicle long after it has lost much of its value. However, real estate generally appreciates over time, which makes home equity financing more attractive when money is spent to improve a property.
The temptation to spend more.
With a large home equity loan or HELOC, you may be tempted to buy a car you can’t afford. Adding large amounts of debt when buying a depreciating asset could jeopardize your house and your finances if you run into unexpected issues.
The Bottom Line
Experts generally agree that using your home’s equity to finance a car is less than desirable. Not only are you investing in a depreciating asset, but you are also using your most valuable asset for collateral, and if things go bad, you could lose your home. Conventional wisdom is that you should try to improve the terms on a standard auto loan before using home equity to buy a vehicle. You can do this by increasing the size of your down payment, getting pre-qualified, or raising your credit score before you shop for a car.
That said, there are some instances when using home equity to finance a car purchase makes sense. If you’re considering this as a financing option, understand the consequences and choose after you’re fully aware of what you’re doing.