Bella Wans is interested in buying a new motorcycle. She has decided to borrow t

Question

Bella Wans is interested in buying a new motorcycle. She has decided to borrow the money to pay the $20,000 purchase price of the bike. She is in the 30% federal income tax bracket. She can either borrow the money at an interest rate of 5% from the motorcycle dealer, or she could take out a second mortgage on her home. That mortgage would come with an interest rate of 6%. Interest payments on the mortgage would be tax deductible for Bella, but interest payments on the loan from the motorcycle dealer could not be deducted on Bella's federal tax return.

a.Calculate the after-tax cost of borrowing from the motorcycle dealership.

b. Calculate the after-tax cost of borrowing through a second mortgage on Bella's home.

c.Which source of borrowing is less costly for Bella?

d.Is there any other consideration that Bella ought to think about when deciding which loan to take out to pay for the motorcycle?

Explanation / Answer

Answer:

a.

After-tax cost of borrowing from the motorcycle dealership would be 5%(same as before-tax cost of borrowing) as interest payments on the loan from the motorcycle dealer could not be deducted on Bella's federal tax return.

b.

After-tax cost of borrowing through a second mortgage = Interest rate * (1 - tax rate) = 6% * (1-.3) = 4.20%

c.

Cost of borrowing through a second mortgage on Bella's home is less costly. it is 4.20% after tax as compared to 5% in borrowing from the motorcycle dealership.

d.

Bella ought to think about following when deciding which loan to take out to pay for the motorcycle-

1. Increase/Decrease in future rates of both type of loans.

2. Requirement of any other loan in future from mortgage.

3. Probability of change in tax bracket.

4. Formalities to be fulfilled in both type of loans.

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