Problem:
Rick and Stacy Stark, a married couple, are interested in purchasing their first boat. They have decided to borrow the boat's purchase price of $100,000. The family is in the 28% federal income tax bracket. There are two choices for the Stark family: they can borrow the money from the boat dealer at an annual interest rate of 8%, or they could take out a $100,000 second mortgage on their home. Currently, home equity loans are at rates of 9.2%. There is no problem securing either of these two alternative financing choices.
Rick and Stacy learn that if they borrow from the boat dealership, the interest will not be tax-deductible. However, the interest on the second mortgage will qualify as being tax-deductible on their federal income tax return.
a. Calculate the after-tax cost of borrowing from the boat dealership.
b. Calculate the after-tax cost of borrowing through a second mortgage on their home.
c. Which source of borrowing is less costly for the Stark family?