Bill William intends to purchase a new racing car. He has decided to borrow money to pay the $500,000 purchase price of the car. He is in the 40% federal income tax bracket. He can either borrow the money at an interest rate of 10% from the car dealer, or he could take out a second mortgage on his home. That mortgage would come with an interest rate of 8%. Interest payments on the mortgage would be tax deductible for Bill, but interest payments on the loan from the car dealer can not be deducted on Bill’s federal tax return.
a. Calculate the after-tax cost of borrowing from the car dealership.
b. Calculate the after-tax cost of borrowing through a second mortgage on Bill’s home.
c. Which source of borrowing is less costly for Bill? Is there any other consideration that Bill should think about when deciding which loan to take out to pay for the racing car?