As housing prices continue to skyrocket throughout the U.S., anyone who has owned a home for a few years probably has built up a nice chunk of equity.  And thanks to the ubiquitous home equity loan, lenders have made it very easy for you to tap your precious home equity.  Does it make sense to take out a home equity loan or a home equity line of credit (HELOC) to finance the purchase of a new car (or pay for a vacation or pay down your student loans)?

At first glance, borrowing against your home equity to purchase a car makes perfect sense.  You can probably get a lower interest rate than you could with a traditional auto loan - especially if you're in the market for a used car.  Plus, you get to deduct the interest paid on up to $100,000 of home equity loan debt if you itemize your deductions.

Let's look at an example where:

• You plan to borrow $30,000 to purchase a car.

• You can take out a traditional auto loan with a rate of 7%.

• Or you can use your HELOC with a rate of 5%.

With an interest rate of 7%, expect to pay approximately $2,000 of interest during the first year alone on the traditional auto loan.  And since car loan interest generally isn't tax deductible to you, the after-tax cost of the interest you pay that year is equal to the amount of interest paid, or $2,000.

How much will the HELOC cost you in after-tax dollars?  Assuming a combined federal/state tax rate of 30%, the after-tax interest rate on your HELOC is only 3.5% (5% * 70%), or half the rate charged on the 7% car loan.  You'll pocket about $1,000 in savings the first year alone.

But if you look beyond the numbers, perhaps a traditional car loan becomes a more attractive option. 

What happens if interest rates dip, and you decide to lock in the lower interest rate by refinancing your mortgage?  When you refinance, it's a common practice to roll your outstanding mortgage balance and home equity loans into your new mortgage. 

Let's say that rates dip six months after you purchase your car, and you still owe $27,000 on your equity loan in connection with its purchase.  If you decide to roll your equity loan into your new mortgage, you'll end up paying for that car over the term of your new mortgage.  No one in their right mind would ever take out a 30 year car loan!!  Even if you hold onto your cars for an average of six years, you'll own five different cars over the next 30 years while you continue to make payments on your new mortgage, which now includes the money borrowed to purchase your car. 

Another pitfall arises if you plan to sell your home soon after purchasing your car.  Since all outstanding mortgages and equity loans are automatically paid off with the sales proceeds at closing, any money borrowed on your HELOC reduces the money available from the sale of your home to put down on a replacement home - resulting in a higher monthly mortgage payment.  Plus, you might end up paying a higher interest rate or PMI if you can't come up with a 20% down payment for your new home.

Anyone subject to the Alternative Minimum Tax (AMT) needs to be careful as well.  While you can deduct interest paid on the first $100,000 of home equity debt when calculating your tax liability, that interest isn't deductible when calculating the AMT (excluding interest on home equity proceeds used to improve your property or refinance existing qualified mortgage debt).  And until Congress either amends or repeals this tax, there's a good chance you'll find yourself paying the AMT in the near future if you're not already paying it.

So while tapping your home equity might be more convenient and cheaper than taking out a traditional auto loan, watch out for the potholes in the road if you decide to take that route.