The most common method for purchasing a new car is through an auto loan. However, auto loans aren’t the only financing option available. Homeowners might consider leveraging their home equity to buy a car, either through a home equity loan or a HELOC (Home Equity Line of Credit).
This strategy carries significant financial implications compared to an auto loan and requires careful consideration. Here’s how to decide if using a home equity loan for a car purchase is the right choice for you.
Should I use my home equity to buy a car?
Frankly, no. Avoid using home equity to buy a car if possible.
With a home equity loan, your home serves as collateral. If you miss payments, the lender can foreclose on your home, meaning you could lose it.
The same applies to home equity lines of credit (HELOCs). While you can use a HELOC to buy a car, it’s not advisable. This line of credit also uses your home as collateral, putting one of your most significant assets at risk.
Generally, it’s best to use home equity for expenses that enhance your financial or professional well-being, such as home renovations or college tuition. Cars depreciate over time, so it doesn’t make sense to secure a car loan with your home. You’d be repaying a loan for an asset that loses value, unlike real estate, which typically appreciates, especially with improvements.
Differences between home equity loans and auto loans
| Auto loans | Home equity loans | HELOCs | |
|---|---|---|---|
| Collateral required | Car | Home | Home |
| Typical repayment terms | 2 to 7 years | 5 to 30 years | 10 to 20 years (after 5-10 year draw period) |
| Usual rate type | Fixed | Fixed | Variable |
| Repayment schedule | Monthly | Monthly | Monthly (can be interest-only during the draw period) |
| Fees | Origination fee (generally a flat amount) | Closing costs (avg. 1% of borrowing amount) | Closing costs (avg. 1% of borrowing amount); account maintenance fee |
Home equity loans and auto loans are both types of secured debt, meaning they are backed by collateral. A car loan is secured by the car you purchase, while a home equity loan is secured by your home. If you fail to repay, the lender can seize the car or the house, respectively.
The repayment terms for these loans differ significantly. You might have up to 30 years to repay a home equity loan, compared to the typical two to five years for an auto loan. This extended repayment period can result in lower monthly payments for a home equity loan compared to a five-year car loan, depending on the amount borrowed.
However, it’s important to remember that a car is a depreciating asset. By the time you finish repaying a 15- or 20-year home equity loan or HELOC, the car’s value will have significantly decreased. According to Edmunds, a new car loses about 23.5 percent of its value after one year and 60 percent within the first five years.
If you’re considering a home equity loan to save on interest, think again. While home equity loans used to offer lower interest rates than auto loans, this trend has reversed. As of May 2024, new car loan rates (starting as low as 5.64 percent) are generally lower than home equity loan rates (starting at 7.67 percent).
Auto loan rates can vary widely depending on your credit score and whether the car is new or used, sometimes exceeding 16 percent. Home equity loans usually have a narrower rate range, not exceeding 13 percent currently, but much depends on the borrower’s creditworthiness.
Additionally, home equity loans often come with closing costs, typically around 1 percent of the principal but sometimes ranging from 2 percent to 5 percent. This is an expense you wouldn’t incur with an auto loan.
The pros and cons of using home equity to buy a car
Home equity loans and HELOCs used to be popular financing options because their interest was tax-deductible regardless of how the funds were used, as long as you itemized deductions on your tax return. However, the Tax Cuts and Jobs Act of 2017 changed that. Now, the interest is only deductible if the loan is used for improving, repairing, or buying a home, and itemizing deductions has become less common overall.
Given these changes, the risks of using a home equity loan for a car now outweigh the rewards. Let’s explore the pros and cons of using a home equity loan versus a car loan to buy a vehicle.
Pros of using a home equity loan to buy a car
- Longer Term, Lower Payments: Home equity loans allow for repayment over a much longer period compared to car loans. While car loans typically last between two and five years, home equity loans can span from five to 30 years. Borrowing only what you need for the car with a longer repayment period can lead to significantly lower monthly payments, all other factors being equal.
- Better Interest Rate and More Money: Home equity loan (HE Loan) and HELOC interest rates are generally less influenced by your credit score compared to auto loan rates. While your credit score is still important in home equity financing, your equity stake in your home also plays a crucial role. This equity determines not only how much you can borrow but also affects the interest rate offered. Therefore, if you have substantial equity in your home, it might be cheaper to obtain a home equity loan, even with a lower credit score.
- Flexibility in Using Funds: A home equity loan or HELOC provides more flexibility in how you use the funds. For instance, if you take out $50,000 of your home’s equity, you could allocate $20,000 to buy a car and the remaining $30,000 to remodel your kitchen. This approach is financially sensible because the larger portion of the loan improves your home, potentially increasing its resale value. Additionally, the interest on the amount used for home improvements might be tax-deductible if you itemize on your tax return.
Cons of using a home equity loan to buy a car
- Decreased Equity: Taking out a home equity loan reduces your ownership stake in your home, which has serious implications. You might need that equity in an emergency, or you could end up with too much debt between your first mortgage and the home equity loan. This could impact your finances if you need or want to sell the home in the future, as home equity loans must be repaid in full when a home is sold.
- More Onerous Application: Applying for home equity financing is more complex and time-consuming than getting an auto loan. The process is similar to taking out a mortgage, where the lender will evaluate your financial situation, the home’s value, and your ownership stake. Approval can take weeks or even months, compared to just days for an auto loan.
- Foreclosure Risk: If you fail to repay the home equity loan, you risk losing your home—a much more significant asset than a car. Unlike defaulting on a car loan, where you only lose the vehicle, defaulting on a home equity loan can lead to foreclosure.
- No Financial Gain: Cars depreciate over time, so with a long-term home equity loan, you might end up paying for an asset that isn’t worth much by the time the loan is repaid. If your car becomes unusable, you could find yourself repaying a home equity loan while also needing to finance a new vehicle.
- Closing Costs: Home equity loans often come with upfront closing costs. If you can afford to pay these, you might be better off using those funds for a down payment on an auto loan instead. This way, you avoid depleting your home equity and potentially incurring additional costs.
In Conclusion
Using your home equity to finance a car purchase is possible, but it comes with significant risks. Given the rising interest rates on home equity loans and HELOCs, it’s generally wiser to compare auto loan offers first.
This advice holds especially true if you’re considering a home equity loan solely for buying a car. However, if you intend to use part of the loan for the car and the rest for investment-worthy projects, like building a new garage to house your vehicle, tapping into your home equity can still make sense.