Using home equity loan to buy a car

Q. Dear Dr. Don, We are looking to buy a used car and trying to think of a better way to finance the purchase. I found out that we could take out a second mortgage, which is tax deductible, to finance the car purchase versus getting a straight car loan. Is this a good idea? Thanks.

A. Dear Tamara,
For people who have a fair amount of discipline in how they manage their finances, a home equity loan or home equity line of credit (HELOC) can make perfect sense as a way to finance a car, new or used. If you're struggling with large credit card balances or have problem credit, a home equity loan might not be right for you.

Not everyone can make use of the mortgage-interest deduction when filing his or her income tax return, but if you're using the deduction now on your first mortgage, odds are you'll be able to use it on your home equity loan, too. IRS Publication 936, Home Mortgage Interest Deduction 6, lays it all out. Talk to a tax professional if you're still not sure.

By being able to deduct the interest expense, you reduce the effective rate of interest on the loan. The interest expense on a conventional auto loan isn't tax-deductible. As I write this, Bankrate's national average for a HELOC is 8.09 percent and 7.8 percent for a home equity loan. The national average for a three-year auto loan on a used car is 8.88 percent. If you're in the 25-percent marginal federal income tax bracket the effective rate on the HELOC is about 6 percent.

A HELOC is a variable-rate loan, and the interest rate is normally tied to the prime rate. Since the prime rate moves in lock step with changes in the targeted federal funds rate, and that rate has been rising steadily for more than two years, it takes a bit of courage to sign up for a HELOC to finance your car.

In contrast, a home equity loan will have a fixed interest rate, and the loan payments are self-amortizing, meaning the payments are large enough to pay the interest expense and pay off the loan over the life of the loan. In the early years of a HELOC, its required loan payments are interest-only, and you have to have the financial discipline to make principal payments, too.
You can use the Bankrate rates home equity rates search tool to comparison-shop for a loan or line of credit.

A car is a depreciating asset. You don't want to take 10 years to pay off the loan on a car that you'll drive for five years. Regardless of which loan you choose, plan on paying off the used car over the time you expect to own it. That way you'll have some equity in the car when you go to buy its successor.