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Reader Question: Should I Pay Off My Car Loan Early?
By JLP | November 11, 2007
Here’s a recent email (edited slightly) I received from a reader regarding whether or not to pay off a car early:
Hello,
I am wondering if you can help me out with some investment math. I can’t tell if i’m doing something wrong, but I’m too close to the data to see it. here’s the question -
I have a car loan that goes through 3/2011 and the current balance is $18,000. My monthly payment is $490 and the interest rate is 6.25%. I have enough cash to pay the loan off, but I can’t figure out if it the right thing to do.
Here’s what I figured:
Keeping the loan:
41 months remaining on loan
$18k loan balance
$490 payment
$20,090 total paid in loan + interest ($490 41) $2,090 in interest paid$18k in savings account
4% interest rate (currently it’s at 4.50, but i’m lowering for possible future drops)
41 months
$20,986 balance at end of 41st month
$2,986 in interest earned+$970 if I keep the loan
Pay the loan off:
$490 monthly payment to savings
4% interest
41 months
$21,754 at end of 41st month
$1,664 interest earned$1,664 - $970 = $694 more money earned if I pay the loan off now.
I also have pros/cons
Paying early pros: no debt, more money earned at end of original loan date.
Payoff early cons: depleted cash reserves, takes 35 months to reach original cash balance, must save that 490 to savings every month.
Keep loan pros: forces me to “save” or keeps me from recklessly spending extra cash, keep Cash reserves.
Keep loan cons: costs $200 a year in interest ($694/3.45 years), credit score impact.
I guess the real question is, can I live without having the cash over the next 3 years or put another way, am I willing to pay $200 a year to keep $18k.
Any help you provide is greatly appreciated. I didn’t use exact numbers but they are close enough. Thanks.
Thomas
Here’s my response:
Although I get different numbers when I perform the math, the end result is the same.
Keeping the Loan
First off, I’ll show you how I did the math:
If Thomas keeps the loan and invests the $18,000 at 4% per year, at the end of 41 months, he will have a cash balance of $20,631.
Remember the formula for future value is:
FV = PV × (1 + i)n
where:
i = .04 ÷ 12 = 0.003333 (remember we are using monthly numbers so we have to adjust the annual interest rate to a monthly rate)
n = number of months
Plugging in our numbers, we get a formula that looks like this:
FV = $18,000 × (1 + .003333)41
FV = $18,000 × 1.1462
FV = $20,631
Paying Off the Loan
If Thomas pays off the loan early, he will lose out on the growth of the $18,000 over the 41 month period but he will be able to save his $490 per month at 4%. Going this route, at the end of 41 months, he will have a cash balance of $21,561.
To figure this out, we’ll have to use the future value of an annuity formula, which looks like this:
FVIFA = [((1 + i)n - 1) ÷ i] × (1 + i)
Plugging in our numbers, we get a formula that looks like this:
FVIFA = [(1.14618541 - 1) ÷ .003333] × 1.003333
FVIFA = [.14618541 ÷ .003333] × 1.003333
FVIFA = 43.85562292 × 1.003333
FVIFA = 44.00180833
Now we simply multiply the monthly savings amount ($490) by the FVIFA solved for above and we get an ending cash balance of $21,561.
The Bottom Line
Based on these numbers, Thomas comes out ahead $930 ($21,561 - $20,631 = $930) by using his $18,000 in savings to pay off his car and then investing the monthly payment ($490) at 4%. This really shouldn’t be a surprise to anyone since his loan is costing him more than he can earn in a savings account. Yes, theoretically he could invest the $18,000 in stocks for potentially bigger returns but I didn’t mention this because that’s not what he asked for. Therefore I assumed he wanted to keep his $18,000 liquid if he decided not to pay off his car early.
Those are my thoughts. Did I miss anything?
Good luck Thomas!
Topics: Budgeting, Financial Math Basics, Miscellaneous |
November 11th, 2007 at 6:00 pm
One option not mentioned is to pay off a chunk of the car, refinance the loan to see if he can get a lower rate on a lower balance. If he can get his interest rate on the care loan lower than that of the bank account he can make money.
November 11th, 2007 at 6:31 pm
What about the taxes on the interest he earns? The interest will be taxable at federal, state and local rates.
November 11th, 2007 at 10:17 pm
A five-year CD at ING direct is returning 5%. That would bring him to to $21,348 over the first 41 months of the 60-month term. Subtracting the cost of 41 stamps, 41 envelopes, and the time it takes to pay the payments, that really only leaves a couple of hundred dollars. If building a decent credit history is an issue, keeping the loan might be worth it.
As Jeremy said, the big difference will be the taxes. Pay off the loan and you’re getting a 6.25% tax-free return on your money.
Oh, and there’s the good feeling that comes with being out of debt.
November 12th, 2007 at 10:18 am
If Thomas wants to have liquid reserves he should probably keep paying the loan. The interest rate is so low that his savings from paying the loan off early are not that much.
Depending on his emergency fund requirements (3-6 months) once he has additional reserves, he could pay off the loan in a lump sum and still have enough cash reserves to sleep well at night.
January 22nd, 2008 at 11:13 am
as a follow up, if anyone is interested, based on the recent federal rate cuts, I am going to pay off my loan. Some notes about the comments - no I don’t have bad credit (who gets a car loan at 6.5% with bad credit?), yes I have an emergency fund (better now that I drop $500 a month in bills), and you can’t get lower rates on a used car.
Of course I’m losing money keeping the loan by the numbers. My point was more around deciding if a couple hundred bucks over 4 years was worth the security of having cash on hand. Now that the difference between savings and the loan rate is greater, that insurance is costing me more and is out of my price range.
I will hopefully take this new money and start investing more in the market as I feel there are a ton of opportunities to make money
January 28th, 2008 at 2:22 am
Paying off ANY loan that incurs interest is a good idea, if you have the funds to do it and are able to save money afterwards. I don’t get why people tell you to keep a loan when in reality, you end up paying hundreds or even thousands more by keeping it? Sure if you’re credit history is an issue (such as not long enough), you can keep it, but to a future lender it counts more for them to see that you paid for it early and in full than just keeping it around. And contrary to what many say, paying off a loan (student, car, etc) early does benefit your credit score to some amount. That’s how my fiance ended up with a score over 800 at just the age of 22. My dad had to work his whole life just to get that same score at 50.
Bottom line is, keeping anything that incurs interest is not a good idea, and needs to be paid off.
April 2nd, 2008 at 4:22 pm
Its never smart to leave your self cash pore.
And never lend your money out.
It will never come back the same as you lent it.
You work to hard to make it.
Learn to say NO!!
I have no money!!!
You might want to think about.
Being a small private lender.
A smart way to lend your money out with a big return
in a short time.
Its safer than stocks.
You are in control of your money.
As the lender you should stay with in a 6 to 8 mo. time
frame for the return of your money.
Deal only with people in need of help with
Home loans and property its a safe loan.
Remember set a Day and time for the payment of the loan.
Get your money back the same as you lend it.
All in one very large payment.
Charge high for late fees.
Set your price high for the loan they will pay.
After doing this the only thing you will be doing
is counting your money.
Good luck hope you do well and keep working hard.
P.S.
Don’t sweat the small stuff!!
May 2nd, 2008 at 3:47 pm
I’m not trying to advertise or anything, but I got 4.5% on a used car at star one credit union which is in the bay area… still i really appreciate this analysis as my situation is similar so i’ve decided to try to pay off my loan instead of holding the money.
September 7th, 2008 at 5:40 pm
I believe that most financial planners would advsie paying it off only if cash reserves are met for at least 3 months of living expenses and you cannot find a relatively safe alternative investment that will yield a greater return.
November 18th, 2008 at 8:50 pm
I think everyone is overlooking one fact.
Loan is better insurance against car that is totaled.
If you pay for the car in full, your insurance company will give you almost nothing if car is totaled.
If you still have a loan, insurance company settles with loan company and you get a new car.
In America, simple maths does not count. What it takes is getting factual information from big rackets.
November 20th, 2008 at 8:58 am
Something I think that got missed in the math…
If he keeps the money, and has $20,631 after 41 months, he will have made $2,631. However he would have paid $2,090 in interest on the car meaning he would have only made $541.
In the payoff example, he pays no interest and still makes $3,561.
I think the gap is bigger than a mere $930. I think its more on the order of $3561-$541=$3020.