It was a little over 3 years ago that I made one of my bigger financial mistakes and bought a $20,000 car. I put $2,500 down and financed the rest on a 5 year loan at a 1.9% interest rate.
As we’ve talked about, the real cost of that was more like $100,000 if you look at what I could’ve done had I invested the extra money I tied up in that car.
What’s past is past though, there’s no changing what’s already been done.
As the remaining balance on my auto loan is about to dip below $7,000 this month and with two years of payments left, I’ve once again had the urge to just get rid of it and pay that sucker off.
Sort of “cleanse” myself of this recurring monthly burden.
Let’s take a look at the numbers, and the two cases of whether I should pay it off or not.
The Case Against Paying The Loan Off
Low Interest Rate
I had this exact same internal debate last year around this time when the loan balance was a little over $10K. If you can recall, I foolishly (wait, yes foolishly) had nearly $30K in cash at the time, so I could have easily paid that off in one fell swoop.
As you can guess, this case won, and I invested that $10K into an ETF that tracks the entire market (VTI) instead of paying off the loan.
My thought was, well, my loan is only 1.9% which isn’t so bad. If I pay off that loan I am essentially locking in a 1.9% return with the $10K.
This kind of return barely keeps pace with inflation, if not getting completely outpaced by it.
Given that the stock market averages a 7% annual return over the long run, it seemed like I’d be missing out on some returns.
As it stands one year later, that ETF is currently up nearly $1,700… a 17% return. Good choice to invest right?
Well, not necessarily. As the $10K would have covered a 3 year loan payoff term, it’s only fair to wait and see how that plays out.
After all, the stock market is risky. While we’ve been in a boom recently, there’s no guarantee that continues.
For all I know, two summers from now the market could be doing poorly and my original $10K investment is worth less than that.
That would mean paying off the loan early would have been the smarter choice.
There’s also a good chance the market continues to climb and my investment grows further, or it stays flat, meaning investing was the right move.
The point is that unless you have a crystal ball, no one knows what the market is going to do.
However, my thoughts were that I would rather take the risk that it goes up more, than lock myself into a return that barely keeps pace with inflation over that 3 year period.
The logic I explained here were the thoughts I had last summer when the loan balance had over $10K remaining, but it still applies to my situation now with $7K remaining (albeit with a shorter investment period of 2 years instead of 3).
More Interest Paid Up Front
Something I’ve only recently come to realize is that with a fixed interest rate, the first payments will have the most interest on them.
The interest paid will go down each month, as the total loan balance decreases.
You can imagine the horror I felt when looking at how much interest is paid up front on 30 year fixed mortgages…
The same thing works for car loans, though the payoff ratio between interest and principal is not as bad due to the shorter length of the loan.
For example, let’s take a look at my loan to date:
You can see how essentially each month the interest I’ve paid has decreased.
Doing the math for you all, (since I’m such a nice guy 😉 ) I’ve paid $706 in interest to date. Yuck.
As the interest keeps decreasing though, how much more in interest do I have left to pay?
Here’s a future projection, taken from an amortization schedule I put together (which explains why the balances are slightly off):
You can see here, the amount in interest over the last 2 years reduces to very small amounts. There is only about $142 left in interest to be paid on the loan.
Over a two year period do I think I could make more than that with a $7,000 investment? As mentioned in the above section, absolutely.
Again, the stock market is a risky endeavor, though at my age I have plenty of time to bounce back from poor market returns.
With numbers like this, it’s no wonder I made the decision I did last summer.
Let’s take a look at the other potential decision.
The Case Of Paying the Loan Off
Being Debt Free
It’s been four years since graduating college and 3 of those I’ve had this loan. The first year while I didn’t have the loan I was actually putting $300 aside each month which mostly went towards my eventual down payment.
Essentially it’s felt like I’ve been paying off this car ever since graduating. In my mind, that’s a long time.
We know that holding debt can lead to a variety of mental illnesses and stress.
While, I’m in a good enough financial situation where I’ve never had to worry about missing a payment, I do wonder whether there could be some kind of effect it has on a microscopic level, where I don’t even notice it.
As mentioned, that payment has just become second nature, something I’ve always had to do each month.
Being completely debt free would be a great feeling, and knowing that would lift an invisible weight off my shoulders.
Now I would know that in the event of a worst case scenario (if the car got totaled, I think that’s worst case?), I wouldn’t owe any money on the car and could move on to some other car without the remaining payments affecting my decision.
You never want to let debt effect your ability to make decisions, and I think in this worst case scenario it just might.
Increased Cash Flow
Another benefit of paying off this loan is the additional cash flow I would generate every month.
Like clockwork, $302 is withdrawn every month and sent to the loan company.
$302 is no small change. That would be a pretty big amount to add to savings/investing every month.
Instead of setting up an auto payment to the loan company, this could turn into an auto payment into a Brokerage account!
As I’m currently looking to purchase a rental property, the additional $300 each month would help me feel a little more at ease as well, given the uncertainty around maintenance, repairs and any potential vacancies in the future.
Knowing I could afford this just with the extra money from my day job would help me feel way more at ease.
With additional monthly cash flow, I have options of what I can do. It gives me more flexibility.
Having this loan gives me no options as that $302 is already earmarked to pay against debt.
Should You Pay Off Low Interest Loans?
Clearly, this comes down to whether or not I’m making the decision with my heart or my brain.
The numbers don’t lie, if I’m looking to maximize return, holding onto the debt and investing now is the way to go (brain).
If I’m looking to potentially be a little more stress free and at ease with future endeavors (especially in real estate) paying the loan off now is the right move (heart).
To add to the situation, if I earmark $7K for loan payoff, that will almost surely push my goal of purchasing a rental property to next year.
That wouldn’t necessarily be a bad thing as it gives me more and more time to really cover all my bases and know what I’m getting myself into. However, at some point, I’ve gotta make the leap if I ever want to do this.
While the decision I made last summer seems be the right one so far, as mentioned who knows what the next two years will look like.
Pessimists will say with rising interest rates, trade war fears and after an incredibly long boom period for stocks, we’re due for a pullback.
Optimists only have to point towards the last 10 years to get me excited.
The decision this year is much harder than I remember it being last year!
I haven’t truly made up my mind yet. Analysis paralysis you might say (that happens to me quite often I’ve found).
Hopefully I will come to a decision soon enough, and move on from it either way.
Maybe some of you all can help me out with this decision! What would you do in this situation? Do you currently carry any non-mortgage debt? Would you lock yourself into such a small return? How much do you prioritize cash flow?