Beware of home equity loans to buy a car

Is a customer better off to use home equity to buy an automobile? Or is dealer-financing a better option? Let's explore.

Home equity loans became popular after a 1986 law phased out tax deducting consumer interest for installment loans and credit cards. They did, however, leave the deduction available for a second mortgage or home equity loan. The idea was that the deduction would be used for improvements to the household, therefore, improving the value of the property.

Unfortunately, it wasn't foreseen that this opportunity would be misused, mostly for automobile purchases. The use of a person's equity towards a car loan has created a financial burden to many people.

Here's how:

A customer purchases a new vehicle for $25,000. Instead of taking out a car loan, they'll use the equity in their home. At the time of purchase, they receive a free and clear title and a low monthly payment because home equity loans are typically set up with a minimum monthly payment like a credit card, or longer term.

Three years later, the customer decides to purchase another car. Now their car is worth about $12,500, but since they are paying a low monthly payment, they still owe $18,000 or more on their home equity loan. They buy a new car for $30,000 minus their free and clear trade of $12,500 and they now have to finance $17,500 while still owing $18,000 on the previous loan. This is where the vicious cycle begins.

Here's advice from the Federal Reserve Board Consumer handbook on what you should know about home equity lines of credit:

"If you are in the market for credit, a home equity plan may be right for you or perhaps another form of credit would be better. Before making this decision, you should weigh carefully the costs of a home equity line against the benefits. Shop for the credit terms that best meet your borrowing needs without posing undue financial risk. And, remember, failure to repay the line could mean the loss of your home."

In other words, home equity loans might not always be the best form of financing for the customer.

But remember, people buy for their reasons, not ours. Pointing out the problems with their choice might not always be the best option. I prefer to take the road that gives us the best opportunity to retain their financing, and not run clown their choice and potentially cause customer dissatisfaction.