Maybe You Shouldn’t Pay Off Your Car Loan

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Having excess funds is considered a good problem. Even Warren Buffett agrees. He has currently over a billion in cash and he does not know what to do with it.

My problem is not as good though. Like I have the ability to pay off my car loan, but I don’t know if I should.

So right now, I’m included in the 45% of Americans whom have a car loan. It’s true that, unless you have some classic or rare exotic vehicle, a car is a depreciating asset. I don’t even know if I would call it an asset.

But the question is do I want to take an asset (cash) and use it to pay off, arguably a large expense (car loan). Or would I rather use the asset to purchase more assets.

Basic Debt/Invest Considerations

There are always advantages and disadvantages when you pay debt VS invest.

Apart from quantifying the costs, there is peace of mind when you pay off debt. There is a psychological feeling of freedom that you don’t owe anyone anything and can own your asset free and clear.

There may be the feeling that did I use my money wisely and could it have worked harder for me. Or, I really hope nothing goes wrong with this car because I just poured all this money into it.

Of course when you are investing in the stock, you are taking some level of risk of losing a little or lot of your money. The risk is adjusted based on your investment style. For example, it’s higher if you select a few individual stocks in a rapidly growing industry. And it’s lowered if you invest in the broad market which includes hundreds of stocks.

My Car Loan “Situation”

I’m fortunate in that mine is at 2.39% (and for a used car) so it’s favorable compared to the country as a whole since the average car loan rate in the United States is around 4.5% for a 5-year loan.

At the time of this writing, my car loan balance was about $10,000 with about 3 years left on the loan.

If I decide to invest $10,000, I can accumulate $12,250 through investing the $10,000 at a 7% rate of return.

And by using the $10,000 and paying your car off early by three years, I can save a total of $372.73 in total interest.

So the simple cost benefit is a cost of $1,877.27 ($2,250 – $372.73) if I were to pay off my car early. And for my specific case, I’ll continue to pay off my car loan because I am borrowing cheap money. I can use my excess funds and invest in the market, with enough comfort that it is a better uses of funds.

If the market continues to fly high the way it has been over the past several years, I may be able to can earn more than 7% by. For example, the Vanguard Total Stock Market ETF – VTI has returned over 11% the past three years.  

Not Always the Case

In contrast, if your car loan is 20% or over, which is unfortunately not so uncommon, then yes it’s imperative to pay off your car loan as quickly as possible. The interest paid for borrowing $10,000 at 20% over 3 years is $3,378.

And chances are if you’re interest rate is 20% or higher, you may not have the funds to pay your car loan off early. In this case, it may be a good idea to see if you can refinance your loan to a lower rate.

If that’s not possible easier, try to pay the car loan off before 3 years are up; maybe in 2 years by making extra payments from a bonus or tax return.

Using Your Emergency Savings

Many experts will say that paying off your car loan is not considered an emergency.

If your interest rate is astronomically high, dipping into your emergency savings may be a good idea. This too depends on some factors:

  • Is your interest rate 20% or over?
  • Do you owe $10,000 or more on your car?
  • Are you a two-income household?
  • Do you have other income streams apart from employment?
  • Do you have a plan to replenish your emergency savings?

If you’ve answered yes to the questions above, it can be a good idea; if no maybe not.

Emergencies are unforeseen situations. What if you suddenly lose your job due to downsizing? Or what if you’re involved in a major accident that leaves you unable to work or have to take care of someone else which requires you to take extended and unpaid leave? Situations like these happen all the time and it’s when you need some love from your emergency savings that is.

Are You Disciplined Enough?

So you decide to pay off your car loan early. Now you got an extra $300-$400 of cash flow every month, Wohoo!

What’s the first thing you should do? SHOPPING SPREE?! Nope, if it’s me, I’d take out $50 and got to a nice steak dinner to celebrate. Then I’d quickly (like after I finish eating and before I get my restaurant bill) use my smart phone to automate and deploy those newly found funds to buy shares of an ETF every single month.

Pretend like you haven’t really paid off your car (even though you have). Pretend like this money isn’t for you (even though it is for the future you).

If your car payment was $300 and you’ve saved $50 more by reducing the car insurance coverage you need, you now have $350 per month being invested. In 3 years and 7% interest, this will accumulate to almost $14,000!

Again, there needs to be discipline in your financial plan so that you’re consistently deploying the funds from your excess cash flow into your investments.

Join the Discussion:

  1. Do you have a car loan? If so, are you planning to pay it off early?
  2. What’s your car loan’s interest rate?
  3. Have you determined how much you can save by paying it off? Is it worth it?

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