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The Tough Decision Whether To Pay Off Low Interest Loans

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.

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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?

14 thoughts to “The Tough Decision Whether To Pay Off Low Interest Loans”

  1. I would keep making the payments because, as you mentioned, most of the interest has already been paid due to loans being front-loaded. Banks want their money back quickly!

    I made a very similar mistake with my car. I purchased a new car at the end of 2016/beginning of 2017. It cost around $23,000 after taxes and fees. I put a little more than half of that down ($10K from the sale of my old car + around $2K of my own money, I forget the exact amount). In the end, I financed a bit over $11,000 at 2.39% for 5 years. The scheduled monthly payment was $202.

    I remember being with the finance manager at the dealership and he drew up two contracts for me to consider: one including the $10K from the sale of my previous car in the down payment and one without it. By nature, I’m very debt-averse. As I was trying to get the interest rate down, he said he’d bet I could put that $10K in the stock market and make much better than 2.39% over 5 years. At the time sitting there and under the gun to make a decision I was thinking, nah, this is just another shady car dealer trying to get me to fork over more money by financing a larger amount…maybe he’s right but I just really want to finance as little as possible and get it over with.

    Well…a year and a half later and removed from the pressure of making a decision like that on the spot, I’m convinced that finance manager was right and I was wrong, especially because that $10K missed out on the epic 2017 stock market ride (of course, I didn’t know that would happen at the time but that’s the risk you take, for good or for bad). To compound this mistake even more, my debt-averse self threw significant extra money at the loan throughout 2017 to pay it off. I paid it off around Thanksgiving. What did I save in the end? A measly $700 in interest over 5 years.

    It’s nice not having a car payment for the last 8 months and moving forward (hopefully years to come, knock on wood 🙂 ). My car has only a little over 15,000 miles on it to date and I play to drive it into the ground. That extra $200 a month is helping to build up an emergency fund in my new online savings account, as well as adding some extra to my regularly scheduled brokerage contributions. However, that is the ONLY benefit. It was a mistake and I would NOT do it over again. Honestly, I can’t believe I was that stupid with this decision. I’ve been great with numbers my entire life but simplistic short-term thinking, combined with not wanting to deal with a car dealer’s finance people and an obsessive debt-aversion probably cost me a lot of money over the long run.

    As you said, what’s done is done. I can’t fix this mistake but I can learn from it. I recently took on a 15 year fixed rate mortgage for a small property that my family and I are going to share in a different state, with the goal of me building up equity and eventually moving to that area when I retire or selling it for a nice profit eventually. I learned from the mistake with the car loan and will NOT be putting extra money towards this mortgage, with the only possible exception being if the market is experiencing a bad year at some point. Even then I will debate at the time if/when that situation arises because investing in a bad market when prices are discounted is historically a great opportunity.

    Sorry for the very long comment but I wanted to share my experience and hopefully that helps with your decision!

    1. The finance manager may have been right in the short term, but as I mentioned you gotta look over it from the life of the term! When it’s all said and done the market could potentially decline over that 5 year period, but I know what you mean… I’d think I’d rather be a little more risky while I’m younger and search for those bigger returns.

      There’s nothing wrong with being debt averse though! I think this is a tough decision and I’m sure being debt free from that auto loan has helped you out being a little more stress free. It’s one less thing to worry about!

      I think (like me) you’re being a little too hard on yourself. That money you used to pay the loan off went to somewhere good instead of spending it on stuff you wouldn’t need 🙂

  2. I had a similar dilemma with paying off my mortgage versus investing. I paid my 30 yr mortgage off in 9.5 years and even though if the money had instead been put in the market it would have generated a lot more money, the peace of being debt free is one of the best non-monetary rewards you can give yourself.

    And you are correct, once you pay off that debt, it’s like getting a tax free raise (since you were sending after tax money to the lender in the first place). My mortgage was close to $5k/mo. Essentially I now have $60k/yr tax free to invest in, which I have been doing.

    It’s a smaller scale of course with a car, but knowing you are free and clear of debt is rewarding. Plus you can even drop down on insurance coverage if you choose to.

    1. I think it’s tough to put a price on being debt free, but the peace of mind knowing you own your house and owe nothing must be amazing!

      The extra cash flow you get from not paying off debt cannot be understated and can really help if I’m looking to invest steadily over a period.

      I didn’t even think about potentially dropping down on insurance coverage but that’s a great point!

  3. That’s such a tough decision and one I was thinking about on a much smaller scale with my student loans. On the one hand, I’m glad not to have that debt at all any longer, or the monthly payments (let alone the extra I was throwing at it). On the other, as small as those amounts were, that money would’ve been best served being invested instead. Oh well. Your interest rate is way lower than my already-low student loan interest rates so you’d definitely get a better return in the market (or possibly in the future, since rates are finally creeping up, in a savings account with a high interest rate haha).

    Maybe since you can’t really go wrong here, some sort of compromise is in order: keep on with your monthly payments and throw some extra towards the loan when you feel like it. Or decide in a year you’re done with the loan and pay it off early in one fell swoop! 😂

    1. I think you’re right in that this is a decision that you can’t get wrong. The extra cash flow is enticing as well as the peace of mind, but I’m also searching for maximum returns and potentially a rental property! I may have to re-evaluate and make the final decision in a few months 🙂

  4. I’d do neither. I’d sell the car and buy a $7,000 used car. The differences in the car loan vs investing are a distraction from the real opportunity to get rich, which is to minimize the crazy big costs in life. Those are housing and vehicles. I can afford to buy any car I want with cash now, but it is because I never borrowed money to buy expensive cars.

    1. This makes sense so long as I can sell my car at the value Kbb says it’s worth. However, at this point if I’m gonna spend $7K I’m gonna avoid all the hassle of selling my car and getting an older car that’ll require more maintenance costs and will need to be replaced sooner than this one. I do agree with the premise, but to me it’s just not worth it.

  5. The cash flow factor is the one thing that gives me pause, because, like you said, that’s $302 you HAVE TO pay every single month, no matter what. Just like a home, a bank can take back a car that’s 99% paid off the same as one that’s 1% paid off. That said, your career seems pretty stable and you aren’t (currently) looking to make a big move like working for yourself any time soon, so I would probably let it ride for now. Unless, of course, you’re paying a lot more in car insurance because you have to pay for full coverage.

    1. Exactly.. I really think the fact I have to pay that every month could limit my decision making in the future should I ever want to strike out on my own. I think I’m going to re-evaluate later this year when the loans a bit lower (and maybe I have a rental property by then!)

  6. Ugh, this is the same debate with paying off a mortgage that haunts me every month I strike that mortgage check. Do I continue with my high savings rate, or do I a portion of that to go to paying off the house early (even though my interest rate is rather low)?

    I feel like I know the pros and cons to both but it still hasn’t helped me make a clear decision…

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