Learn when it makes sense to use home equity to finance a car purchase and key factors to weigh in your decision.
Finding the cash you need for significant expenses such as buying a car can be overwhelming. That’s where loans come into play.
Traditional auto loans are usually the best financing option when buying a car. That’s because with that option, you are not using your home, for instance, as collateral for the purchase. But if interest rates are more favorable for a home equity loan, it could be an alternative to consider when purchasing a car under the right circumstances.
This article will help you understand these financial tools and determine if they’re a good solution for your own personal situation. We’ll explore what these options are, as well as their pros and cons, and offer practical tips for making smart financial choices.
We’ll also review other ways to finance your vehicle and take you through the steps of applying for these loans, providing you with helpful knowledge to make a well-informed decision about using your home equity for major purchases like a car.
Buying a new car is always an exciting experience. However, it also requires careful financial planning, especially when it comes to choosing the right type of loan. Two popular options for financing a car purchase are auto loans and home equity loans. But which one is the better choice? In this comprehensive guide, we’ll compare auto loans and home equity loans to help you make an informed decision.
Overview of Auto Loans
An auto loan is a type of secured loan specifically for financing the purchase of a car. The car itself serves as collateral for the loan. Here are some key features of auto loans:
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The loan amount is based on the purchase price of the car,
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Loan terms typically range from 2 to 7 years.
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Interest rates are determined by factors like your credit score, loan amount, loan term etc. The average new car loan rate is around 5%.
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You make fixed monthly payments over the loan term.
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The lender can repossess the car if you default on the loan.
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Auto loans are easy to qualify for as long as you have a steady income.
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The loan application and approval process is quick and straightforward.
Auto loans offer many benefits that make them ideal for financing cars:
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Low interest rates – On average, interest rates for auto loans are quite low compared to other types of financing. This keeps your total borrowing costs manageable.
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Predictable payments – With fixed rates and terms, your monthly payments remain the same over the life of the loan. This allows you to easily budget for the expense.
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Fast process – You can get approved and funded for an auto loan in a matter of days. This enables you to quickly move forward with your car purchase.
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Easy qualification – Auto loans have relatively flexible eligibility criteria. As long as you have a steady income, you should qualify for an auto loan.
Overview of Home Equity Loans
A home equity loan lets you borrow against the equity or market value you’ve built up in your home. The home serves as collateral for the loan. Here are some key attributes of home equity loans:
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The loan amount is based on your available home equity, typically up to 85% of your equity.
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Loan terms range from 5 to 30 years.
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Interest rates are fixed but higher than auto loans, currently averaging around 7-8%.
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You make fixed monthly payments over the loan term.
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The lender can foreclose on your home if you default.
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Qualification is tougher than auto loans, factoring in home equity, credit score, income etc.
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The application and approval timeline is longer at 2-6 weeks.
While home equity loans have higher costs and risks, they offer a few advantages:
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Higher loan amounts – You can access more funds for large purchases based on your substantial home equity.
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Lower monthly payments – The longer repayment terms lead to lower monthly dues.
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Interest may be tax-deductible – You can deduct interest paid on up to $750,000 of home equity debt on your tax return.
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Consolidate other debts – A home equity loan allows you to consolidate and repay other more expensive debts.
Auto Loan vs Home Equity Loan – Which is Better for a Car?
Now let’s directly compare auto loans and home equity loans to determine which financing option makes more sense for buying a car:
Interest Rates and Costs
Winner: Auto Loans
Auto loans are clear winners when it comes to interest rates and overall costs. Average new car loan rates are around 5% right now versus 7-8% for home equity loans. Even used car rates can be lower than home equity financing. The fixed monthly payments are also typically lower with an auto loan versus a home equity loan for the same loan amount. Auto loans don’t involve any upfront fees or closing costs either.
Loan Amounts
Winner: Home Equity Loans
If you need to finance a very expensive luxury or specialty car, a home equity loan may allow you to borrow more based on your home equity. For example, you may only get approved for a $50,000 auto loan but could potentially get a $100,000 home equity loan. The larger pool of funds from a home equity line makes sense for a pricier ride.
Qualification Ease
Winner: Auto Loans
Qualifying for an auto loan is a relatively simple process as long as you have a steady income. Home equity loans have stricter eligibility criteria that also factor in your equity, debt-to-income ratio, credit score and home appraisal. The underwriting is similar to a mortgage application. Thus, auto loans are much quicker and easier to qualify for.
Approval and Funding Speed
Winner: Auto Loans
You can complete an auto loan application in minutes online or at a dealership. Once approved, the lender can fund the loan in a day or two so you can immediately take delivery of your new car. The home equity loan process is more complex, often taking 4-6 weeks between paperwork, appraisal, underwriting and finally funding. So auto loans have a clear edge in terms of fast approvals and funding.
Risks and Collateral
Winner: Auto Loans
A home equity loan puts your house at risk as collateral if you default. With an auto loan, you only risk losing the car itself. Given that a car depreciates rapidly, an auto loan poses less financial risk overall than using your more valuable home as collateral. The potential to lose your home through foreclosure makes home equity loans riskier.
Flexibility
Winner: Home Equity Loans
A major plus with home equity loans is you aren’t limited to using the funds just for a car. You have the flexibility to use the money for other purposes like home improvements or debt consolidation too. An auto loan must be used specifically to purchase a vehicle. So home equity offers greater flexibility in usage of the loan money.
Key Takeaways: Is a Home Equity or Auto Loan Better for a Car?
After comparing the pros and cons, it’s evident that auto loans are usually the best option for financing a car purchase. Here are some key reasons why:
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Lower rates and costs – Auto loan interest rates and monthly payments are more affordable.
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Less risk – Your home isn’t on the line as collateral with an auto loan.
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Faster process – Auto loan approvals and funding are quicker, enabling a fast car purchase.
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Easier to qualify – Auto loan requirements are relatively easy to satisfy.
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Car-specific – The funds must be used specifically to buy a car.
The main advantages of home equity loans are the ability to borrow larger amounts and use funds for other purposes too. But the higher rates, tougher approval, lengthy process and risk of foreclosure make them impractical for buying cars.
In most situations, an auto loan is the optimal way to finance a car. But a home equity loan can be considered if you need to buy an extremely expensive vehicle, want to consolidate other higher-cost debts, or need funds for other uses in addition to the car. Carefully weighing the pros, cons and risks allows you to make the financing decision that best aligns with your needs and financial situation.
Final Tips on Auto Loans vs Home Equity Loans
Here are some final tips to guide your decision between an auto loan and home equity loan:
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Compare multiple lender quotes for best rates on both options before deciding.
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Crunch the numbers to see monthly payments you are comfortable with.
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Evaluate your current finances and don’t overborrow simply because more funds are available.
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Understand the risks and collateral implications of each option.
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Be pragmatic and don’t use home equity unless you have a compelling reason to.
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Don’t borrow more than you need just because larger home equity amounts are available.
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Read all loan terms carefully and consider consulting a financial advisor if undecided.
By following these tips and weighing all considerations covered in this guide, you can make a well-informed, financially sound decision on funding your next car purchase!
Understanding the Application Process
Applying for a home equity loan involves several key steps to secure financing against the equity you’ve built up in your home.
- Assessing your home’s equity: The first step is determining how much equity you have in your home. Lenders typically require a minimum amount of equity to consider your application, often around 15% to 20% of your home’s value.
- Choosing lenders: Once you know your home’s equity, it’s time to shop for lenders. You can start with your current mortgage provider, local banks, credit unions or online lenders. Compare interest rates, loan terms and fees to find the lender that best fits your needs.
- Completing an application: After selecting a lender, you’ll need to complete an application. The application typically includes providing personal and financial information, details about the loan amount you’re seeking and the purpose of the loan. The lender will perform a credit check to assess your creditworthiness.
- Providing documentation: Lenders will require documentation to verify your financial stability. Documentation may include proof of income, tax returns, bank statements and details about your existing mortgage. Be prepared to provide a list of your assets and debts.
- Undergoing appraisal: A crucial step in the process is the home appraisal. The lender will hire an appraiser to assess the current market value of your home. The appraisal helps determine the maximum loan amount you can qualify for, as it’s based on a percentage of your home’s appraised value.
- Closing the loan: Once your application is approved and all necessary documentation is in order, you’ll move on to the loan closing. During this stage, you’ll review and sign all the loan documents. The lender will ensure that you understand the terms and conditions. After closing, the funds will be disbursed to you, often as a lump sum.
Tapping into your home equity through a home equity loan can be a valuable financial tool, but it’s not without its risks. It’s important to be aware of the potential consequences, especially the risk of losing your home and the impact on your ability to refinance your mortgage.
When you use your home as collateral for a loan, you’re putting your home on the line. You must make the payments on the home equity loan to avoid losing the equity you’ve built over the years. That’s because the lender may have the right to foreclose on your property to recoup its money. It’s a daunting scenario that underscores the need for careful financial planning and budgeting to ensure you can meet your repayment obligations.
Missed payments can lead to a downward spiral. If you consistently miss payments on your home equity loan, your credit score may suffer, making it even more challenging to secure loans or mortgages in the future. When you can’t qualify for competitive mortgage rates, it can limit your ability to refinance your existing mortgage or take advantage of better financial opportunities.
Drawbacks of Using Home Equity for a Car Purchase
- Home collateral: When you use home equity, your home serves as collateral. If you can’t make the payments, you risk losing your home to foreclosure. It’s a substantial financial risk that must be carefully considered.
- Borrowing limits: The amount you can borrow is limited by the available equity in your home. If your home’s value is not significantly higher than your mortgage balance, you may not be able to access a substantial amount. Your creditworthiness may also play a role in the amount you can borrow.
- Closing costs: Home equity loans often come with closing costs, including application fees, appraisal fees and more. These costs can eat into the savings you might gain from lower interest rates.
- Mortgage refinancing impact: Using home equity may impact your mortgage terms and rates. If you refinance or take out a home equity line of credit (HELOC), it could result in higher total borrowing costs over time and potentially extend the overall repayment period.
- Longer repayment: Yes, a longer repayment term can be an advantage but also a disadvantage. A car is a depreciating asset. Your new car could lose as much as 20% of its value within the first year. By year five, your car may be worth only 40% of its original value. Financing a depreciating asset over a long period may not always be in your best interest.
HELOC Vs Home Equity Loan: Which is Better?
FAQ
Is it smart to pay off car with home equity?
Is it harder to get a home loan or a car loan?
Is an auto equity loan a good idea?
What is a disadvantage of a home equity loan?
Can a home equity loan buy a car?
Using a home equity loan to buy a car can seem like a great idea: Your house serves as collateral, and you use the payout to buy a car at a far lower interest rate than you’d get with an auto loan. That can mean lower payments and more buying power, too. However, using home equity to buy a car comes with some big risks and drawbacks.
What is a home equity loan?
A home equity loan allows you to borrow money against the ownership stake you’ve built up in your home. Sometimes called a “second mortgage,” it uses your property as collateral for the fixed-rate debt, which you pay back in monthly installments, with interest.
What is the difference between a car loan and a home equity loan?
Home equity loans and auto loans are both types of secured debt: that is, they are backed by something that acts as collateral for the loan. While a car loan is secured by the car you purchase, a home equity loan is secured by your home. In both cases, if you fail to repay, the lender has the right to seize, respectively, the car or the house.
Are car loan rates lower than home equity rates?
Now, many auto loan offers are lower or comparable to the rates on home equity products: As of May 2024, new car loan rates (starting as low as 5.64 percent) were averaging several percentage points lower than home equity rates (starting at 7.67 percent). Of course, these are averages.