As housing prices continue to skyrocket throughout the U.S., anyone who has owned a home for a few years probably has built up a nice chunk of equity. And thanks to the ubiquitous home equity loan, lenders have made it very easy for you to tap your precious home equity. Does it make sense to take out a home equity loan or a home equity line of credit (HELOC) to finance the purchase of a new car (or pay for a vacation or pay down your student loans)?
At first glance, borrowing against your home equity to purchase a car makes perfect sense. You can probably get a lower interest rate than you could with a traditional auto loan - especially if you're in the market for a used car. Plus, you get to deduct the interest paid on up to $100,000 of home equity loan debt if you itemize your deductions.
Let's look at an example where:
With an interest rate of 7%, expect to pay approximately $2,000 of interest during the first year alone on the traditional auto loan. And since car loan interest generally isn't tax deductible to you, the after-tax cost of the interest you pay that year is equal to the amount of interest paid, or $2,000.
How much will the HELOC cost you in after-tax dollars? Assuming a combined federal/state tax rate of 30%, the after-tax interest rate on your HELOC is only 3.5% (5% * 70%), or half the rate charged on the 7% car loan. You'll pocket about $1,000 in savings the first year alone.
But if you look beyond the numbers, perhaps a traditional car loan becomes a more attractive option.
What happens if interest rates dip, and you decide to lock in the lower interest rate by refinancing your mortgage? When you refinance, it's a common practice to roll your outstanding mortgage balance and home equity loans into your new mortgage.
Let's say that rates dip six months after you purchase your car, and you still owe $27,000 on your equity loan in connection with its purchase. If you decide to roll your equity loan into your new mortgage, you'll end up paying for that car over the term of your new mortgage. No one in their right mind would ever take out a 30 year car loan!! Even if you hold onto your cars for an average of six years, you'll own five different cars over the next 30 years while you continue to make payments on your new mortgage, which now includes the money borrowed to purchase your car.
Another pitfall arises if you plan to sell your home soon after purchasing your car. Since all outstanding mortgages and equity loans are automatically paid off with the sales proceeds at closing, any money borrowed on your HELOC reduces the money available from the sale of your home to put down on a replacement home - resulting in a higher monthly mortgage payment. Plus, you might end up paying a higher interest rate or PMI if you can't come up with a 20% down payment for your new home.
Anyone subject to the Alternative Minimum Tax (AMT) needs to be careful as well. While you can deduct interest paid on the first $100,000 of home equity debt when calculating your tax liability, that interest isn't deductible when calculating the AMT (excluding interest on home equity proceeds used to improve your property or refinance existing qualified mortgage debt). And until Congress either amends or repeals this tax, there's a good chance you'll find yourself paying the AMT in the near future if you're not already paying it.
So while tapping your home equity might be more convenient and cheaper than taking out a traditional auto loan, watch out for the potholes in the road if you decide to take that route.
Go to your local bank, and you can probably earn 1% on your savings account and maybe 4% on a Certificate of Deposit (CD), assuming you're willing to tie up your money for 3 years. Some on-line banks, such as ING DIRECT, are offering 3% on money invested in their money market accounts without the time requirement of a CD.
Through the U.S. Government's site, www.treasurydirect.gov, you can invest in U.S. Savings Bonds yielding 3.5% interest, I-Bonds (discussed in our April, 2004 newsletter) currently yielding 4.8%, or Treasury Bonds that are paying around 4.0% for a 10 year commitment.
Mutual funds give you access to fixed income securities as well. At mutual fund giant Fidelity, you can invest in money market accounts yielding 2.75%, short-term bond funds yielding 3.5%, high-yield bond funds yielding 6%, or an intermediate municipal bond fund paying 3.25%.
More sophisticated investors also have the option of investing in individual bonds, such as bonds issued by the U.S. government or its agencies, corporations, or even state and local governments or their agencies.
How Interest Income is Taxed
With such a variety of interest bearing investment opportunities available, how do you know which ones makes the most sense for you? Start by learning how each type of fixed income security is taxed. Don't forget that all of your investments grow tax-deferred within your retirement accounts.
For your investments held within your taxable accounts, here are the basics:
When investing in mutual funds that hold interest bearing securities, how you're taxed depends on the fund's underlying portfolio. For example, if you invest in a fund that holds only U.S. Treasury bonds, the dividends you receive from that fund are exempt from state income taxes.
Calculate the After-tax Return
The next step is to determine the after-tax return you'll realize from different types of investments. To keep our calculations simple, let's assume you can earn 5% on any type of fixed-income investment.
This table reflects the after-tax return on investments yielding 5% for a person in the 25% federal tax bracket and 5% state tax bracket:
When trying to decide which investment opportunity to pursue, there's more to look at than just the after-tax return you'll earn on an investment. It's very important to understand the risk associated with each of your investments. If the organization that issues the debt can't pay its bills, you could end up losing all the money you invested. Generally, the higher this risk, the greater the interest rate paid on those bonds.
Your fixed income portfolio is also subject to "interest rate risk". As interest rates rise and fall, the value of your interest bearing investments might fluctuate as well. Generally, as interest rates rise, the value of your bond portfolio decreases.
Bank issued investments, such as savings accounts and CD's, as well as certain government investments such as U.S. Savings Bonds or I-Bonds, aren't subject to interest rate risk. These investments pay you back the amount of money originally invested plus any interest earned. For most other types of bonds, however, the longer the time before the bond matures, the more volatile the bond's value as interest rates rise and fall.
Talk to a Pro
To find out more about how your investment portfolio will be taxed, you can contact the MDTAXES CPA from your metropolitan area. And for investment advice about designing your portfolio, please contact the closest advisor included on our Directory of Financial Advisors.
copyright - 2005 - The MDTAXES Network