A cash-out refinance allows homeowners to convert their accrued home equity into cash. This cash can be used for anything, including paying off other loans.
But is paying off your auto loan with a cash-out mortgage a smart money move? As with most personal finance matters, the answer is: it depends.
What to consider
If the decision were based solely on comparing the average interest rates for car loans with those of new mortgages, the answer (for most people) would be no.
But there’s more to good money management than interest rate comparisons.
Factors that should be considered include current and future cash-flow needs, the amortization schedules and tax deductibility of your loans, asset depreciation and your credit score.
In some cases, it might be wise to consolidate your consumer debt (including auto loans) with a cash-out refinance, even if you’re unable to lower the interest rate.
Auto loan Rates vs mortgage rates
A cash-out refinance involves taking out a new mortgage for more than your outstanding balance. You then pocket the difference between the new and old loans.
If you recently took out an auto loan, it’s likely that the interest rate is identical, or even slightly lower, than the rate for a cash-out mortgage.
In 2016, the average rate for new vehicles was in the low four percent range, and for used cars, the high four percent range.
At the moment, the average rate for a conventional 15-year fixed mortgage is just about four percent, and it’s around 4.5 percent for a 30-year fixed mortgage.
Even if auto loan rates climb to 4.5 percent (new cars) and 5.2 percent (used) this year, which some experts are predicting, it’s unlikely you’ll save money by paying off a car loan with a cash-out refi, especially when you factor in the closing costs associated with new mortgages.
For cash-out mortgages, closing costs typically range from three to six percent of the loan.
Keep in mind, too, that while most houses rise in value, the value of automobiles always depreciates – usually quite fast.
So if you obtain a new 15- or 30-year mortgage to eliminate the car loan, you’re financing a depreciating asset by taking out equity from an appreciating asset.
When paying off a car loan with a cash-out refi makes sense
If your car loan is relatively new, chances are that most of the monthly payments made in the first year or two are going to go toward interest, and not toward the principal.
In that case, getting a cash-out refi to pay off the loan could save you hundreds of dollars in interest charges, assuming there’s no prepayment penalty.
Another argument in favor of getting a cash-out refinance is that, unlike car loans (and almost every other form of consumer debt), mortgages are tax deductible.
By reducing your taxable income and landing a bigger tax refund, you could potentially save thousands of dollars a year.
To determine whether you’ll come out ahead by using a cash-out mortgage to eliminate your auto loan(s), contact your current lender to obtain an amortization schedule, or go online and look for an amortization calculator.
With this tool, you can figure any financial benefits you’ll receive by eliminating the auto loan with a cash-out refinance.
If math and money management isn’t one of your personal strengths, consult with a financial planner or an accountant instead.
Paying off credit cards is a “no-brainer”
Deciding what to do about an auto loan can involve numerous calculations and some close judgment calls, but that’s rarely the case when it comes to using cash-out refinances to consolidate other types of consumer debt, especially credit card debt.
Swapping credit card debt for a new mortgage is often a “no-brainer.”
The average credit card today carries an interest rate ranging from 10-20%, plus cash-advance fees and “penalty rates” for late-payers or people with lower credit. By consolidating this debt with cash from a new mortgage, you can reduce your interest rate to just four or five percent.
In addition, you’ll enjoy more cash-flow flexibility. With consumer debt, there could be frequent changes to interest rates, minimum payments, and terms, making it difficult to know exactly how much you’ll owe from month to month.
By contrast, a fixed-rate mortgage bundles everything into a predictable monthly payment.
Paying off credit cards with a cash-out refinance can also improve your credit score by reducing your credit utilization ratio (the amount of available credit you’re using).
The danger with debt consolidation, of course, is when someone refinances their mortgage to eliminate consumer debts, and then turns around and racks up new debts.
If you do this, and then you need or want to buy a new home, you could end up with no equity in your existing house, or possibly something worse.
If deficit financing has become a way of life, debt consolidation with a cash-out mortgage is not the solution.
Before you apply for a cash-out mortgage, make sure you’ll receive at least one of the following three benefits: a shorter loan term, lower monthly payments, and lower costs over the term of the loan.