Compare tax deductable interest rate to non-deductable interest rate

In this example, you will not be paying enough annual interest to itemize, and therefore will not be able to take advantage of the tax deduction. Don't let the tax tail wag the dog.

Elizabeth Richardson

You can approximate the effective interest rate of a tax-deductible loan by subtracting your marginal tax rate times the interest rate. So in your case:

r_eff = (1 - 25%) * 6.8% = 5.1%

That's not EXACTLY the whole story, but it's pretty close. Also, interest on the new loan is probably deductible from your state income taxes, as well. This has the effect of increasing your marginal tax rate, so you'll save even more money with the tax-deductible loan.

As Elizabeth pointed out, this all depends on being able to deduct the interest in the first place. There's also the question of whether this is a good idea. A typical setup for this situation is taking out a 2nd mortgage to pay off a car or a credit card. This seems like a good idea on the surface, but it can get you in to trouble.

Credit card debt is unsecured debt. If you can't make the payments, nothing really happens except your credit score plummets. A car loan is secured by your car. If you fail to make the payments, they repo your car. But a mortgage is secured by your HOUSE. If you stop making those payments... the bank might foreclose on you. That's a lot worse than having your credit score tank or losing your car.

--Bill

I agree with what the other responders have said, and add one more caveat... that the loan terms are equal. If you are rolling a car loan with, say, 36 months left on it into a mortgage with a term of 360 months, you will pay far more interest on the car under the new loan than the old one. In fact, you will be paying interest on the car long after it has worn out and rusted away in the junk yard.

Dave