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, the thrill of the purchase can sometimes overshadow the importance of choosing the right financing option. Two popular choices for financing a car purchase are home equity loans and auto loans. But which one is better for your needs? In this comprehensive guide, we’ll compare home equity loans vs car loans to help you make the best decision.
What is a Home Equity Loan?
A home equity loan allows homeowners to borrow against the equity they’ve built up in their home Equity is the difference between what your home is worth and what you still owe on your mortgage
For example, if your home is worth $300,000 and you have $200,000 left on your mortgage, you have $100,000 in equity. With a home equity loan, you can tap into a portion of that equity – say $50,000 – and receive it in a lump sum.
Home equity loans have fixed interest rates and a set repayment term, usually between 5-30 years. The home itself acts as collateral for the loan, meaning failure to repay could result in foreclosure
What is a Car Loan?
A car loan, also known as an auto loan, is a type of secured loan specifically used to finance the purchase of a car. The car itself serves as collateral for the loan. If you fail to make payments, the lender can repossess the vehicle.
Car loans typically have 2-7 year repayment terms and can feature either fixed or variable interest rates. The rate offered depends on factors like your credit score, income, and the car’s price and age (new or used).
Key Differences Between Home Equity and Car Loans
While both allow you to finance a major purchase, there are some important distinctions between home equity loans and auto loans:
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Collateral: A home equity loan uses your house as collateral whereas a car loan uses the purchased vehicle as collateral.
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Loan amount: Home equity loans allow you to borrow a larger sum, up to 85% of your home’s value. Car loans max out around $50,000 for high-end luxury vehicles.
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Interest rates: Currently, average auto loan rates (5-10%) are lower than home equity loan rates (7-13%).
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Repayment term: Home equity loans have longer repayment terms of 5-30 years. Car loans are shorter at 2-7 years.
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Fees: Car loans may have origination fees of 1-5% of the loan amount. Home equity loans also require closing costs averaging 1% of the amount borrowed.
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Tax deductibility: The interest on car loans is not tax deductible. With home equity loans, the interest is only deductible if used for home improvements.
Pros of Using a Home Equity Loan for a Car
Despite the risks, there are some potential upsides to tapping home equity over a traditional auto loan:
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Lower monthly payments: The longer repayment term results in smaller monthly payments. This improves cash flow and makes the loan more affordable.
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Higher approval odds: Home equity loan approval depends partly on home equity. Even with poor credit, strong equity could help you qualify.
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Interest savings: In some cases, current home equity rates are lower than auto loan rates, especially for borrowers with lower credit scores.
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Access more funds: Home equity loans provide significantly more financing, which could allow you to buy a more expensive car.
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Use funds for other goals: Unlike a car loan, you’re not limited to using a home equity loan only for a car. The funds can also go toward other aims like home repairs.
Cons of Using Home Equity to Buy a Car
On the other hand, there are also some significant drawbacks to be aware of with home equity auto financing:
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Risk of foreclosure: If you fall behind on repayment, you could lose your home to foreclosure. With a car loan, the lender can only repossess your vehicle.
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Reduced home equity: Tapping equity through a loan decreases your ownership stake in your home. This can limit options later if you need to borrow against equity again.
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Complicated application: Getting approved for home equity financing takes much longer than a car loan. The application is also more invasive.
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Car depreciation: Vehicles lose significant value over time. With a 30-year home equity loan, you may end up “underwater” and owe more than the car is worth.
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Prepayment penalties: Home equity loans sometimes charge expensive prepayment penalties if you pay off the loan early. Car loans generally don’t have prepayment penalties.
Home Equity Loan vs Car Loan: Which is Better For You?
With the pros and cons of each option covered, how do you decide what’s right for your situation? Here are key questions to ask yourself:
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How long do you plan to own the vehicle? If you drive cars for many years, a longer home equity loan term with lower payments may work. For a car you’ll trade in after a few years, a shorter car loan makes more sense.
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What’s your credit score? Borrowers with lower scores may benefit from a home equity loan over a car loan. For those with very good credit, current auto loan rates are competitive if not better than home equity financing.
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How much equity do you have? Strong home equity expands home equity loan options and improves your chances of approval. With less than 20% equity, a car loan is the safer choice.
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Are you borrowing exclusively for the car? Car loans can only be used for vehicle purchases. Home equity loans provide flexibility to borrow for other needs at the same time.
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How stable is your financial situation? The foreclosure risks of home equity loans make them a poor match if your income or employment is unstable. Opt for an auto loan to limit exposure.
Tips for Getting the Best Financing
Whichever route you choose, a little preparation goes a long way in securing favorable financing terms:
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Check your credit reports. Errors could be needlessly dragging your credit scores down. Dispute any inaccurate items.
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Pay down existing debts. Lenders like to see lower credit utilization and minimal monthly obligations. Paying down credit cards and other loans improves this key ratio.
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Shop around with multiple lenders. Compare loan offers from banks, credit unions, and online lenders. More quotes equal more bargaining power.
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Opt for shorter terms. Shorter terms mean less interest paid over the life of the loan. Make sure payments fit comfortably in your budget.
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Ask about discounts. Many lenders offer discounts for setting up autopay, having an existing account, or buying additional products like insurance.
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Come prepared with docs. Having pay stubs, tax returns, and bank statements ready speeds up the application process and improves your chances.
The Bottom Line
When financing a car purchase, homeowners have a choice between tapping available home equity or taking out a traditional auto loan. While home equity loans boast benefits like lower monthly payments, easier qualification, and increased borrowing power, they also carry significant risks like foreclosure. For most car buyers, auto loans are the safer, more prudent choice. But for those with extensive home equity, strong finances, and plans to keep the car long term, home equity loans could potentially deliver more value. Carefully weigh the pros and cons for your specific situation before moving forward.
Auto Loans vs Home Equity Loans
Just as with a home equity loan, an auto loan is a secured loan. The difference is what is the collateral for the loan, your home or your car.
Auto loans traditionally have a fixed rate, but do have flexibility in terms of length of repayment. The monthly payment also takes into account your creditworthiness and down payment. Improving your credit score and having a good down payment will help lower your rates and therefore your monthly payment. You can receive auto loan rates either directly from a dealership or through a bank or other traditional lenders.
Perhaps the most important factor is that a car is a depreciating asset, meaning the value decreases over time. Home equity loans are best used for either debt consolidation or home renovation projects – acts that appreciate either your buying power or the value of your home.
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
What is the downside of a home equity loan?
Is it smart to pay off car with home equity?
Is it easier to get a home loan or car loan?
Is it a good idea to use a HELOC to buy a car?
Can I use my home equity to buy a car?
It’s possible to use your home equity to take out a loan for a car, but it’s a risky move. With the interest rates on home equity loans and HELOCs creeping up, it makes more sense to compare auto loan offers first. Of course, this assumes you’re taking out a home equity loan for a car purchase – and nothing else.
What is the difference between a home equity loan and auto loan?
Just as with a home equity loan, an auto loan is a secured loan. The difference is what is the collateral for the loan, your home or your car. Auto loans traditionally have a fixed rate, but do have flexibility in terms of length of repayment. The monthly payment also takes into account your creditworthiness and down payment.
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.
Can a home equity loan finance a car?
You can use the money from a home equity loan to buy anything you’d like, including a car. Since these loans have low interest rates and low monthly repayments, this can seem like a good deal. However, it’s generally not a good idea to use a home equity loan to finance a car purchase. In this article, we’ll explain why.