NEW YORK (sbup — You’re ready for a new car, have decided to buy rather than lease and now want to find the best loan. In today’s conditions, should you go from a standard car loan from a dealer or bank, or look to a home-equity or margin loan?
Standard car loans are pretty attractive, ranging from about 3.2% for a 36-month deal to just under 4% for a 60-month loan, according to the manybanking.com survey, But because home values have been rising, you may be able to get a home equity loan and perhaps deduct your interest payments from your federal income tax. (Talk to your tax expert.)>
The stock market has been rising, too, making a modest margin loan from your broker less risky. (Margin interest payments are deductible only if the loan bought taxable investments, which doesn’t include vehicles.)
So the first question is, do you itemize your federal tax return, and are you likely to for the life of your loan? If you don’t — and a majority of taxpayers do not — the tax deduction for home equity interest doesn’t apply to you. That means the interest rate you pay is your true, after-tax rate, and the average dealer or bank loan will probably be cheaper than the average home equity loan.
If you do itemize, your after-tax rate on the equity would be lower than the official loan rate. Suppose you paid 6% and had a 25% income tax rate. Then a quarter of your interest payment would come back to you through the deduction, making your after-tax rate 4.5%.
While that sounds good, keep in mind that your “tax bracket” really represents the rate on just the last portion of your income. The tax is progressive, meaning the first chunk of earnings is not taxed at all, while additional portions are taxed at ever-increasing rates until that top, or “marginal” rate, is reached. A person in the 25% tax bracket may well pay less than 20% once all this is taken into account.
One way to get a clearer picture of the tax deduction is to figure your total federal income tax as a percentage of your gross income. If the result were 15%, subtract 0.15 from 1 to get 0.85, and multiply that by your loan rate to figure your after-tax rate. That would give a 6% loan a 5.1% after-tax rate — 0.85 x 6.
Then compare that after-tax rate with the rate you would pay on a nondeductible loan, such as one from the dealer. The lower rate is the better deal.
Also remember that each type of loan has certain risks. Stop making payments on a standard car loan and your car will be repossessed. Fail to pay on a home equity loan and the lender might take your home. And if the value of the securities used for collateral on a margin loan falls below a given level, you’d have to put more money or assets into the account or the broker would sell some of your holdings to reduce the debt. Also, margin loans have floating rates, so you could someday pay more than at the start.
Every case is different, of course, but home equity and margin loans don’t generally look as cheap as today’s auto loans. The sbup survey shows, for example, that 60-month home equity loans average about 5.6%. That would be 5.2% after tax if you got a full 25% tax deduction, and a dealer or bank loan might well be cheaper.
Typical margin rates run around 8% for $25,000 to $50,000. That, too, is high relative to standard car loans. The chief benefit of margin loans is that once they are set up, which is easy and free of fees, they are very quick and simple to use.
So most car buyers will probably do best borrowing from the dealer or bank and avoiding the added worries that come with margin and home equity loans. People in the top tax brackets, 35% and up, should take a look at home equity loans, because their tax deductions could be quite large.
—For more ways to save, spend, invest and borrow, visit MainStreet.com.