Whether you take out a personal loan or add it to your mortgage depends to a large extent on personal factors. Will your mortgagee allow you to increase your home loan? Does your credit rating mean a personal loan will carry a higher interest rate? These are important details that may limit your choices.
Perhaps more interestingly, a couple of behavioural factors can also come into play in your situation. The way we organise our money (mental accounting) and the attachment we form to things we own (the endowment effect) can complicate the question.
What’s on the line?
In your full email you say that you cannot afford to pay cash and really do need a new set of wheels. You say you are likely to be charged a lower interest rate adding the new car to your mortgage than taking out a personal loan. This is probably partly because the lender could repossess your property and sell it to recoup the loan if you fall behind on the payments for the car. Be aware of this increased risk. If you are prepared to take this increased risk, the maths suggest increasing your mortgage.
However, it’s not necessarily as simple as this. If you are not careful, you could end up borrowing more than you planned.
If it's good enough for Dustin Hoffman...
Firstly, consider the way you organise your finances. Houses usually have a longer life than cars. Let’s assume your mortgage has 20 years left but a car lasts for five years. If you replace each car by borrowing more on your mortgage, over the next 15 years you will buy four cars and add to your mortgage. If you don’t pay off the extra amount you borrowed for each car over the five years of its life, you will begin ratcheting up the amount you owe on the mortgage each time you buy a car. It can be difficult to keep track of the separate amounts you are paying for the mortgage and the car when they are lumped into one payment.
This helps explain why some people choose to take out personal loans rather than increase their mortgage. It helps them keep track of their money. Behavioural economists call this mental accounting.
Authors and academics Richard Thaler and Cass Sustein explain this on their website and in their book Nudge. The book retells the story of how the Hollywood actor Dustin Hoffman used this approach when he was first starting out on the stage. With little income, he placed money into separate jars so he had enough for food, rent and other expenses. When he asked friend Gene Hackman for a loan for food, Hackman asked why given there were jars filled with money. Hoffman is reported to have simply pointed to the empty money jar labelled "food".
It’s worth a lot to me
Secondly, and perhaps more dangerously, don’t fall for the endowment effect. This is a thinking trap in which people value the things they own at more than the items are actually worth. It might be shares, houses, cars or something else. They become reluctant to sell. An associated effect is that people tend to spend more than they intended when they borrow money to buy something because this emotion becomes involved. An eZonomics blogpost and video explains in more detail. When buying the car on a loan, the endowment effect might lead to a temptation to add extras, such as a fancy sound system or chrome wheels. Paying with cash “hurts” more and the amount of available funds can limit spending – meaning buyers might be more likely to be content with industry standard.
On the road again
You don’t have to fall for these thinking traps if you are organised, disciplined and can resist the patter of the car sales person. Personally, if offered a V8 with extractors and a lowered chasis, my financial resolve would melt like ice-cream in the sun.