Cars are expensive: almost no one is able or willing to drop about twenty thousand dollars cash on a new car and drive it off the lot fully paid for. But since nearly everyone needs a vehicle, automobile financing is a huge industry, standing with student loans and mortgages as one of the three major debts most people will deal with in their lifetimes.
The traditional auto loan is usually negotiated at either a customer’s own bank or with the car dealer with whom the customer is purchasing the vehicle, most of which have their own financing departments. With this type of financing, the car itself is the collateral – meaning that if you ever stop making payments, the vehicle could be repossessed.
But recently another option has been gaining steam: taking out a home equity line of credit to purchase a car. This means that the vehicle itself is not collateral for the money borrowed. Instead, the equity you have in your house is. On the surface, the differences seem minor: after all, in both cases, someone is giving you money to buy a car and you make payments on it until you own everything free and clear. But there are some very important differences between the two that should be closely examined before deciding which type is best for you.
Most advice on financing a vehicle deals strictly with how to handle a standard car loan, and much of that advice exists because the rates can vary widely. State laws on car interest rates as well as general market rates for a given area can result in getting multiple different rates depending on who you are soliciting the credit from. For that reason, it is important to receive quotes on payment terms and interest rates from your own bank, the dealer you are purchasing the vehicle from, and any other potential lenders. Sometimes you can find an especially good deal, say if you have a long history and good relationship with your bank.
One important thing to consider is that cars are depreciable objects. That means that their value declines over time and with use, with most cars expected to have a lifespan of about five years with normal use and maintenance. For that reason, financing very rarely goes beyond a 60-month (five year) term. Many are paid back within three years. This way, even by only making the minimum payment, you completely own the vehicle when the time comes to sell it or trade it in for a new model – after all, you do not want to still be paying for a vehicle that you stopped driving years ago! It also means that you would overall pay less interest total than a longer duration of financing with a similar interest rate.
Another benefit of an auto financing is that the collateral is the object you actually purchased with the loan. That means that if problems come up and you are unable to continue making payments on the car, the worst that can happen is the vehicle is repossessed. Still a bad situation, of course, but the penalty is reasonable.
Finally, because purchasing an automobile is overall a simpler process than with home equity financing , fees associated with the loan outside of basic interest are typically low, simplifying the process.
That interest rate variance that might work in your favor can just as easily work against you. The market for auto loans experiences more turbulence than any real estate financing, so if you happen to be purchasing at a bad time and cannot push it off for a few months, you might get stuck with a substandard rate. Even in the best cases, interest rates will normally be higher than with a home equity option.
These higher interest rates combined with the shorter payback term will mean that minimum payments will be a healthy amount higher than those on home equity. If you tend to make only the minimum payment on everything, this might be good, because it forces you to pay off the car in roughly its useful life span; but if you are the type who likes to make larger payments when money is available without the pressure of meeting a larger minimum month to month, your discipline might lead you to prefer a smaller payment.
Finally, unless you have exceptional credit, most buyers can expect to have some kind of down payment necessary to get acceptable terms on an auto financing agreement. This might be a trade in of your previous car, or it might mean you have to scrounge up a few thousand dollars in cash before driving off the lot.
Home equity loans are so called because they are based on the equity you have in your home. A HELOC is very similar, except instead of a large sum of money paid at once, your home’s equity is used almost like a credit card: purchases are made against it and paid down month to month, with the credit becoming reusable again as soon as it is paid off. Regardless of the type of financing or credit, interest rates will almost always be lower than with an auto financing because the value of real estate tends to be much more consistent than a rapidly depreciating automobile.
In addition, the interest paid on home debt can be deducted when it comes time to do your taxes at the end of the year – something not possible with a traditional auto loan. This means that not only will you likely pay less interest during the year, but depending on your financial circumstances, you could save an additional several hundred dollars on top of that when everything is tallied up.
By negotiating home equity financing prior to going to the dealership to buy a car, you are able to cover the full price of the vehicle upfront (since your agreement is with the lender who services it and the dealership is not involved at any point). That essentially takes all the uncertainty of payment out of the deal for the dealership. That can give you significant bargaining power compared to a customer needing to finance their purchase. Many dealers will even offer a discount without needing to negotiate if the full price of the car is paid immediately.
Home equity typically has a longer term than a standard auto fiancing agreement, usually five or ten years. That can easily outlive the vehicle you’re buying with the money borrowed, meaning if you stick entirely to the minimum payment, you can still be putting money towards a car you stopped driving years ago. That longer term also means more interest will accrue, which can eat up whatever savings you were looking to capture with the overall lower interest rate. If you choose to go with home equity financing, you should be prepared to make extra payments beyond the minimum to avoid these situations; consider calculating what your financial obligation should be to reconcile the loan in just three years, for example, and try and stick to that.
Leveraging home equity may come with variable interest rates, while fixed rates are more common on auto loans. Over the life of the loan, it is possible that interest rates would rise considerably, which might up your monthly payment and overall amount of money borrowed beyond what you initially agreed to. Be sure to check the terms of the contract carefully before agreeing.
Fees and closing costs related to processing of home financing are almost certainly going to be higher than an auto finance agreement. Depending on the equity in your home you are borrowing against, you might also need to purchase a mortgage insurance policy to be allowed to borrow the funds. Carefully calculate the effect of these differences, as they might swallow up savings elsewhere.
Finally, arguably the biggest concern is that you are essentially risking your home to purchase a vehicle. Obviously no one plans to default on their payments, but if the worst comes to pass, defaulting on your car means you lose your car; defaulting on a home equity finance contract means you no longer have anywhere to live. If there is any uncertainty at all that you might not be able to keep up with the financing payments for the entire duration of the agreement, pass on the home credit option.
There is no one-size-fits-all answer for whether you should finance your vehicle with an auto or a home equity loan. Interest rates vary widely depending on when you are borrowing, the market you are in, and your own personal credit score and credit history.
When borrowing any large sum, you should always shop around and get quotes from multiple lenders. The best thing you can do is to simply add a home equity quote to your list when requesting a quote. That way, you can look at all the options side by side for your personal situation and see what fits best. Remember to ask about all associated fees when processing both types, and factor in any potential down payments dealing with auto financing. It is possible that in your market a highly competitive auto industry and slumping home prices could make an auto financing an all around lower cost option.
If the home equity route seems to be the way to go to save money, remember the two major caveats to borrowing against your home: the longer term means you could spend more on interest in total compared to auto financing options if you only make the minimum payment; you might end up spending money on a vehicle that has already outlived its useful life if you don’t make extra payments; and if for whatever reason you become unable to meet your financial obligations, you are at risk of losing your home, not just your vehicle. The extra discipline required and risk associated with a home loan might make it an unattractive option regardless of costs.