Money Answers: if you need debt, what's the smartest type to use?

BusinessDesk investments editor Frances Cook responds to emails from readers each week to answer questions about money. Below you'll find her expert advice. Send your own questions to [email protected].

Hi Frances,

I’m not sure if this is the intent for this email address but I am after some advice.

My wife and I drew down some funds from our mortgage to have available when we were looking at using this as a deposit to potentially invest in an off the plans build with intent to sell prior to completion to make some gains whilst the market was hot.

This didn’t come to fruition and this is now sitting in our savings account. Our fixed mortgage is up next June where we could add this back on.

We are looking at buying a new car. Are we better off using a portion of this money to pay for it or do we get a 5-year car loan for this?

I’m inclined to use our cash but my wife argues that it may be better to use a car loan as even though the interest rate will be higher than the mortgage rate, the mortgage is over a long period so, in the end, we will be paying more.

Is this correct?

Any insight would be much appreciated.

Thanks

T

Hi T,

You’re kind of both right. Which points us towards a middle solution to your issue.

First of all, let’s run the numbers on this. How much you pay for a car loan depends on where you go, how much the car costs, and what sort of credit rating you’ve got.

Depending on these factors, you could end up paying anywhere from 6.99% interest to 18.95%. A major difference there!

Car loan vs mortgage

Let’s run this based on 8%, which assumes that you’re in pretty good financial shape and shop around for a good deal, but also gives us some buffer for you not being perfect, and the loan company pinging you with a couple of extra fees along the way.

So if you get a new car for $20,000, at 8% interest, and pay it back monthly over the next five years, it will likely cost you $24,331.67 in total. You’ll be locking in a $405.53 payment every month for the next five years.

Ok, so how about that same car spread over a 30-year mortgage? There are lots of numbers floating around right now, but several banks are offering 4.99% specials currently (or even a smidge less), so let’s go with that.

Over 30 years, that $20,000 car leaps up in price, to cost you $38,607.17 in total. The monthly payment is only $107.24 this time, which is slightly easier to stomach, but I think we can agree that nearly doubling the price of your car through interest costs is not great.

As your wife noted, this is the power of compound interest at play. Even though the interest you’re being charged is lower, when it’s spread over a longer time, it adds up quite steeply.

However, time for that middle way that I mentioned at the beginning.

A different solution

If you add it to your mortgage, you absolutely don’t have to commit to it being a 30-year loan. You can talk to your bank about the loan running for as long as you want it to. It could be set to a one-year, three-year, or five-year term.

This is one of the major benefits of being a homeowner. You get access to some of the cheapest borrowing rates around, using your house as security for the loan.

So what about if we take that car loan and put it on the 4.99% mortgage, and ask the bank to set it at a five-year term, the same as you were planning to do for your car loan?

Now it only costs you a total of $22,639.98, and your monthly payment over the next five years is $377.33. You’ve slashed the amount of interest that you’re paying, almost in half.

Even better, could you try to get that debt monkey off your back in only three years? You would only pay $21,575.81 overall, with a monthly payment of $599.33. You’ll save yourself a lot of money, and be free of that debt burden two years early.

It also means you wouldn’t be caught paying more if interest rates go up further in the future.

By the way, I’m no maths whizz. I wish. If you want to work this out for yourself, with the actual price of whatever sort of car you’re looking at, I have a shortcut for you.

Check out the loan calculator here.

All you have to do is plug in the amount you want to take out for the loan, the interest rate, and how long you plan to have the debt for.

It then does all the complicated maths for you behind the scenes and spits out a clearer picture of what you’re taking on.

Send questions to [email protected] if you want to be featured in the column. Emails should be about 200 words, and we won't publish your name. Unfortunately, Frances is not able to respond to every email received, or offer individual financial advice.

Information in this column is general in nature, and should not be taken as individual financial advice. Frances Cook and BusinessDesk are not responsible for any loss a reader may suffer.