Cash-out refinance to buy a car (or pay one off)

Can I use a cash-out refinance to buy a car?

When you get a cash-out refinance on your home, there are no string attached to the money. You can use your new funds however you want — including buying a car or paying one off.

However, most experts agree that there are ‘good’ and ‘bad’ reasons to cash out home equity.

Buying a car is typically in the second category. However, if you really need a new vehicle and don’t have the money available, this could be a smart move.

Here’s what you should know before you decide.

In this article (Skip to...)

• How a cash-out loan works
• Cash-out to buy a car
• When it’s a bad idea
• When it’s a good idea
• ’Good’ vs. ‘bad’ borrowing

>Related: The best way to refinance your mortgage

How does a cash-out refinance work?

A cash-out refinance means refinancing your old home loan with a bigger loan, and taking the difference in cash. You can then spend that any way you want. So, naturally, you can use a cash-out refinance to buy a car or pay one off.

Of course, this is an option only for those who are creditworthy, and whose homes are worth considerably more than their mortgage balances. But, if you live somewhere where prices have been rising, and you’ve been paying down your existing loan for some years, there’s a good chance you’ll qualify.

Should you cash-out refinance to buy a car?

Vanishingly few financial advisors will tell you it’s a good idea to use a cash-out refinance to buy a car or to pay off an existing auto loan. Most would even say it’s a bad idea. Read on for the list of compelling reasons why they’re right.

However, personal finances don’t always work that way. For example, it’s bad to use payday loans, right? Well, yes — if you have any choice.

But their high interest rates might be worth paying if you can’t get to work because your car’s broken down and you’ve no other way to cover repairs. Similarly, payday loans can be cheaper than unauthorized overdrafts.

Sometimes, when you’re desperate, the smartest (or only) move you can make is the best one. And that could include cash-out refinancing to buy a car.

Why it’s not a good idea to buy a car with home equity

It’s time to look at those compelling reasons financial advisors will give you against using a cash-out refinance to buy a car. By far the most persuasive is cost.

It’s more expensive up front

Suppose you want to borrow $20,000. Here’s how the numbers stack up:

• Total interest payments on $20,000, 5-year car loan at 5 percent: $2,645
• Total interest payments on $20,000 released through 30-year cash-out refinance at 5 percent: $18,651

You’ll notice that it’s not higher interest rates that are killing you. You won’t get approved for a mortgage refinance unless your credit’s pretty good. So, especially with manufacturers’ and dealers’ incentives, you’ll likely be offered similar rates on both types of borrowing. Indeed, some auto loans come with lower ones than mortgages.

But, even if you don’t get a great deal, you’ll be worse off refinancing: an auto loan at double the rate (10 percent) will cost you “only” $5,496 in interest over the lifetime of the loan. That’s less than one-third what you’ll pay with that refinance. No, what kills you is that you’re borrowing the $20,000 for six times as long.

You could be paying off your car for 30 years

And that brings us to a second compelling reason. You’re borrowing over 30 years (360 months) to own a depreciating asset you’re likely to dispose of long before it’s paid for. A 2017 study by IHS Markit found that Americans on average keep their cars for 79.3 months (6.6 years). If you’re average, you’ll be making payments on your car for 280 months (over 23 years) after you’ve sold it.

Indeed, a 2014 report from IHS suggested the average age of a vehicle when it was scrapped was then 13 to 17 years. So you might expect to end up making payments for 156 to 204 months on a vehicle that has already been crushed into a cubic yard of mangled metal.

With luck, you’ll have completely forgotten by then that you used your cash-out refinance to buy a car. But, now you’ve read this, the thought may haunt you. Sorry about that.

Cash-out refinancing has higher fees

Pretty much all cash-out refinances cost more than straightforward purchase mortgages or refinances where you don’t take cash out. Lenders see your need for cash as an added risk, so they cover that by increasing their charges.

This practice is called “risk-based pricing” or “loan-level pricing adjustments.” And your lender levies its fees on the amount of your new mortgage. So if you currently owe $200,000 and want to add $20,000 for your new car, you’ll pay an extra fee based on $220,000.

Depending on the risk factors you present, you may expect to pay, say, 2 percent of your total loan value in these fees. And on $220,000, that’s $4,400.

Paying $4,400 for an extra $20,000 is a lot (22 percent!) and may mess up the economics of your car purchase. Of course, you can probably add the $4,400 to your new mortgage balance. But then you’d be borrowing $24,400 to buy your $20,000 car — and that will bump up those interest costs even further (44 percent!!).

When to buy a car (or pay one off) with a cash-out refi

The downside of borrowing money over a long period is that the interest you pay is going to add up. The upside is that you’ll be paying much less each month.

Much lower monthly payments with refinance

So, to revisit the same example used above:

• Monthly payments on $20,000, 5-year car loan at 5 percent: $377
• Monthly payments on $20,000 released through 30-year cash-out refinance at 5 percent: $107

If you have to pay 10 percent on your 5-year auto loan, the monthly payment will be $425.

Clearly, that minimum of $270 a month difference between a 5-year auto loan and a 30-year refinance will be critical to anyone currently facing serious cash flow challenges. Indeed, the more affordable option could see a family remain afloat and continue to pay its bills on time. The more expensive one could result in a financial spiral that ends in disaster.

Consider buying a cheaper car

The obvious response to someone considering a cash-out refinance to buy an expensive, high-end car or pay off an existing auto loan is: Don’t!

If you’re truly in need of a car, and you can get a cheaper, used one with your cash on hand, that’s always going to be the best move.

Cash-out refinancing to buy an expensive car you don't need — or pay one off — is pretty universally considered a bad move. You’ll be paying the car off over a long period, there’s usually no return on investment, and your car’s value will only depreciate over time.

So, if you can, look into alternatives first. Can you afford a low-end car with cash? Or buy a more affordable car with lower monthly payments using your current cash flow?

When you’re not just buying a car

The math looks a little different if your new car is part of a long list of essentials you need — and when your mortgage balance is low. Let’s add a twist to our earlier example.

Suppose you currently owe $20,000 (not $200,000) on your mortgage. But you need to borrow $200,000 on your cash-out refinancing, meaning you’ll end up with that same $220,000 loan balance.

You’ll still pay $4,400 in risk-based pricing fees because your lender calculates those on that balance. But you’ll be getting $200,000 rather than $20,000. And that means those fees will be 2.2 percent of your car’s cost rather than 22 percent.

The downside? You’ll have gone from having a negligible mortgage balance to a significant one. And you’ll face paying that down over the next 30 years. That list of essentials will need to be really essential to justify that. And it will have to mostly comprise “good” borrowing.

“Good” borrowing vs. “bad” borrowing

Some people say there’s no such thing as “good” borrowing. But most probably differentiate between loans that are investments in your and your family’s future and those you use to prop up an unsustainable lifestyle that you can’t afford.

Here are some examples of what many would regard as “good” borrowing that could justify a cash-out refinance:

• Unavoidable medical bills
• College costs for you or your kids
• Home improvements — especially ones that will at least eventually enhance the value of your property
• Down payment on an investment property
• Other investments — Providing you recognize that these come with risks, and are prepared to live with possible losses and perhaps with ongoing costs
• Business startup — A different sort of investment that’s likely to carry higher rewards and higher risks
• Debt consolidation — It can be good to pay down high-interest debt using a refinance. But you must first resolve to stick to a sustainable household budget or you’ll soon find yourself back at square one

Using a cash-out refinance to buy a car can be added to that list only if you have a genuine need for one and can’t pay for it any other way.

Of course, you might choose to borrow for things that aren’t financially sound but that provide you with sufficient pleasure to be worth the costs. It’s not “smart” to borrow for your child’s wedding or a once-in-a-lifetime cruise to celebrate a milestone anniversary.

However, with purchases like those, you’re expressing love and buying lifelong memories. Only you can decide whether the necessary loans are worth it.