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!

### 31 responses to Reader Question: Should I Pay Off My Car Loan Early?

1. 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.

2. What about the taxes on the interest he earns? The interest will be taxable at federal, state and local rates.

3. 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. ðŸ™‚

4. 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.

5. 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 ðŸ™‚

6. 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.

7. 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
Good luck hope you do well and keep working hard.

P.S.
Don’t sweat the small stuff!!

8. 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.

9. 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.

10. 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.

11. 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.

12. Is this true?:
“Loan is better insurance against car that is totaled.”

I am in the same situation and have just 6k to pay off my auto loan. I will have enough cash after that to cover me for 6 months in case of emergency.

I have comprehensive collision and liability insurance, so I thought if my car was totaled in a wreck or stolen, I pay the deductible and the insurance company pays me the blue book value of my car, no matter whether it is paid off or not. Is that not true?

13. If you choose the early pay off option.. How does that effect your credit? I’ve heard it’s better (credit wise) to go with the full term.

14. I’m in the same boat – have about \$6k left on a 2008 Honda Odyssey. Loan is at 5.7% – paying it early for the mental well being and were else am I gonna get a 5.7% return?

15. To desh perdesh who said :

“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.”

You are mistaken. Insurance will pay you what the current value of your car is irrespect of how much you owe or if you have a loan on it or not. If your car is worth less than what you owe, then it is your responsibility to pay the difference to the loan company. The insurance company wil lonly pay the loan company the value of the car, not the value of the loan. Thats your responsibility. The only way out of this is if you purhcase addtional GAP insurnce which covers the difference.

16. Ok, so what’s the concensus? I’ve got the same situation as Thomas…Loan balance to payoff my car is \$55k. But I’d rather keep the cash & invest it. My loan is 5.6% & the payoff is 2011. One financial analyst said not to pay it off…but to hold onto the cash. The insurance company’s payout will be based on the value of the car…irrespective of if it has a loan or not.

17. I need some urgent help!!
I am desperate for a solution for my problem.
I owe \$14400 on my car (85,000 miles) and it is worth \$6000. I have about \$7000 that I could take out my savings to do one of these two things: pay that \$7000 towards my current loan and keep up with payments and keep this car untill it doesn`t work anymore , or trade my car in for \$6000, get a newer car for \$12500 (13,000 milage), transfer whatever is left from my current loan to this new loan?
I appreciate it!

18. I have a question. I'm in a situation similar to Thomas. I have a car loan at 6%, with a remaining balance of \$2,500, and 20 months left of a 36 month loan. I have over \$5,000 in savings, but I have a very short credit history, and I know that the length of credit history is a major component in my score. Therefore, I came up with the following plan, and I'd like to hear you guys' advice on whether or not it sounds like a good idea.

I pay the bulk of the balance off, leaving a small balance (\$300-\$500), and I pay that down over the remaining 20 months left on the loan. That way, I cut a huge chunk of the balance off, don't incur nearly as much interest expense, but still retain the loan for the full 36 months, therefore improving my credit score. Does this sound like a winner, or are there probably minimum payments I'd be required to make on the loan?

19. ppd: you are in trouble, pay off the loan and dont buy american cars. I had the same issue with a cobalt. I lost about 10K in 2 years.
aaron: you should keep with that loan. it has to be short money and it will help your credit as long as you pay, just make it an automatic payment and keep the account funded.

20. With the economy in the condition that it is in I would hold on to my cash. You never know about employment. At this date and time just continue to make your payments and pay more towards your principal to reduce the amount that you would pay on interest.

21. Hey all,

I checked out this site because I too am now able to pay off my car loan but wasn’t sure if it was the smarter thing.

My simple logic on the matter was: a car is NOT a “positive” investment…meaning, it only depreciates over time. It’s one thing to pay interest into a home loan (though these days homes aren’t necessarily appreciating, yikes) or art, or other investments that appreciate over time. But to continue to pay interest on something that will only lose value as the clock ticks?

Is that something to consider? Pay off the loan, and instead use the money I would be paying toward the car each month to save and invest in something “positive” later…

22. Alexa,

Since the car depreciates even if you own it out right, it doesn’t really change the math. Paying off the car is going to save you money. The decision really is if you’re comfortable with less cash in the bank.

23. Has anyone taken into consideration that with car loans you pay the interest at the beginning of the loan. So, once you’re interest is paid, all you are payment is going to principal and you really save nothing but the monthly payment every month if you pay it off?? From a saving money standpoint, there’s no gain once you cross that threshold. From a want to be out of debt standpoint, absolutely pay it off if you have the means. But I’d figure out where you are on that threshold before dumping money to pay it off, especially if the montly payment isn’t an issue and you could be making money on your payoff money instead.

24. I’ve been paying on my auto loan for 4 yrs now and have one year left, and I’m about to pay off the loan in total to avoid the interest. my question is how much well my credit jump if any if I do so, by paying the loan off?

25. paying it off early won’t do much if anything for your credit score but its always good to not be in debt. though if you don’t have much of a credit history keep the loan and just pay a lil extra each month to pay it off faster.it will show you make your payments on time and don’t miss by keeping it open.

the huge thing I see that has been left out of this convo is how new is the car and etc.cars over time need maint. factor that in and this changes things alot.I wish I had paid my car off when i first got it then used the money to buy a cheaper car that was very decent then let the rest of the money sit in a savings or etc.

26. Great analysis all! I am in same situation and this analysis helps very much. I agree with Shawn re the interest savings — depends on the loan amortization (where you are in the loan term). I’m in year 4 of a 5 year loan. My balance is \$9k from a \$22800 car loan, after 3 years! I ran the amortization (find any loan calculator online) and the early years of course were all interest but now that I’m in yr 4, it is mostly principal I’m paying and very very little interest. Here’s my numbers for example:
total loan: \$22,790, 5 year term, interest 8.89%, monthly payment \$474.
Interest Principal
Year 1: 1697 3987
2 1504 4179
3 1117 4567
4 694 4990
5 232 5067

You can see that the interest in the later years is much much smaller. So, if I pay the loan off now in year 4, it’s not like I’m really saving 8.89% NOW. I’m saving peanuts now, comparably, and would be giving up my cash position. I’m not sure it is worth it. (Had I the money in the earlier years as I do now, I would have paid it off sooner, but just wasn’t the case.)

The only reason I am tempted to pay off the loan now is to improve my credit score, but I am getting mixed messages about whether that helps or hurts my score. My current score is 700 and I would like to be over 720. I would say that I have enough history so that is not a problem, but having lower debt may in fact raise my score overall.

Anyone?

27. Clearing off the car loan sooner, will, in fact, lower your score. Mine dropped to 709 from 735.

But realize – future lenders will not just look at your credit score, but also your credit history. That is where you will stand to gain when they see a ‘Paid off ahead of loan maturity time’.

Hope this helps!
– Anuj
Boston, MA

28. The best answer is never finance a depreciating asset. While that’s the best answer, few people are in the position to pay cash for a car.

Unless you’re trying to build credit history, pay off the loan ASAP IF you have 3-6 mo. cash reserve.

If you don’t have 3-6 month cash reserved, pay yourself the difference first (saved in an interest bearing cash account), then pay off the loan making double payments, etc.

29. Similar situation here. Owe 12k which I have now in addition to cash reserves. Life being as uncertain as it is, I feel it safer to keep the 12k in case of emergency. If things go south in a hurry, you could simply not pay the loan and have the car repoed. I feel that if things are bad enough, the credit score hit from the repo is the least of my worries. Maybe im just a negative person but that’s just how I feel about it. At the end of the day, the 12k represents almost a year in mortgage payments/rent i could use in case of a potential catastrophic emergency. In such case, I rather have a place to live than a vehicle.

30. I am in a slightly different situation. I just bought the car on a 60 month loan 3 months ago and now I received some money. If I pay a larger amount back in an early stage of the credit, wouldnt that mean that this extra money goes to the principal and I really save on interests?

31. Hope the dude didn’t invest his money in stocks since 2007!