Question

Rico needs approximately $2,500 to buy a new computer. A two-year unsecured loan through the credit union is available for 12.00 percent interest. The current rate on his revolving home equity line is 8.75 percent, although he is reluctant to use it. Rico is in the 15 percent federal tax bracket and the 5.75 percent state tax bracket. Which loan should he choose? Why? Regardless of the loan chosen, Rico wants to pay off the loan in 24 months. Calculate the monthly payments for him, assuming both loans use the simple interest calculation method.

a) The after-tax cost of the home equity loan is ?
b) The payment on the credit union loan would be?
c) The payment on the home equity loan would be?
d) The savings from the difference in payment over the life of the loan is?
e) The tax savings over the life of the home equity loan is?
f) The total savings over the life of home equity loan is?

Answer 1

Rico should choose the credit union loan because it has a lower after-tax cost and monthly payment. The after-tax cost of the home equity loan is $328.13, while the payment on the credit union loan would be $185.42.

Step-by-step explanation:

To determine which loan Rico should choose, we need to calculate the after-tax cost of the home equity loan and compare it to the credit union loan.

For the home equity loan:

Principal: $2,500
Interest rate: 8.75%
Tax rate: 15% federal, 5.75% state

After-tax interest rate = (1 - 0.15 - 0.0575) * 8.75% = 6.5525%

After-tax cost = Principal * After-tax interest rate * Term = $2,500 * 6.5525% * 2 years = $328.13

For the credit union loan:

Principal: $2,500
Interest rate: 12%

Total interest paid = Principal * Interest rate * Term = $2,500 * 12% * 2 years = $600

Now, let's calculate the monthly payments for both loans. We'll use the simple interest calculation method.

For the home equity loan:

Monthly payment = (Principal + Total interest) / Number of months = ($2,500 + $328.13) / 24 = $136.71

For the credit union loan:

Monthly payment = (Principal + Total interest) / Number of months = ($2,500 + $600) / 24 = $185.42

From the calculations, we can see that the after-tax cost of the home equity loan is $328.13, while the payment on the credit union loan would be $185.42. Therefore, Rico should choose the credit union loan because it has a lower after-tax cost and monthly payment.