For anyone who is deeply interested in finance and money management, you have probably heard the debate before about whether someone should pay off or pay down their mortgage. I actually wrote a brief special report on this subject several years ago.
But we don’t often hear any discussion about whether you should pay down or pay off your car loan. Since most people take on debt when buying a car, this is a valid question.
It is reported that Americans are now in over $1 trillion of car debt. This could be the sign of another bubble, but only time will tell for sure.
There are many debates about buying cars. There are debates about buying new vs. buy used. There are debates about buying vs. leasing. There are debates about whether to take on any debt at all to buy a car.
I don’t think there is any one good answer to any of these questions. It often depends on someone’s situation.
While it seems to be smarter financially to buy used instead of new, I don’t think that is as true as it used to be. Sometimes slightly used cars are not as heavily discounted as in the past. If you are going to drive a car for a long time, it may make sense to buy new. Plus, if your time is very valuable (which hopefully it is), you do want something that is reliable and doesn’t require a lot of maintenance.
In terms of buying and leasing, I think it typically makes sense to buy, but again, it depends on the situation. There are times when it can make sense for someone to lease.
In terms of taking on debt, it is just a fact that many people have to take on debt because they don’t really have any money to buy a car. And having a car really is a necessity for most people, as it gets them to work and to the store.
In all of these scenarios, I think the key is that you should not be getting any more car (in terms of price) than what is practical. If you are leasing, or buying new and taking on debt, then you should not be going beyond the basics of what you really need. You don’t need leather seats and extra horsepower to get to work. Most new cars today are pretty powerful as compared to the past.
So what if you do have car debt? And what if you have some extra money lying around? Does it make sense to pay it down or pay it off?
This is somewhat similar to the question about a home mortgage, but I actually think it is simpler and more feasible when it comes to a car loan. Car loans are much lower than mortgages, and the terms of a car loan are far shorter – usually about five or six years as compared to a typical 30-year mortgage.
Let’s say you have 2 years left on a car loan with a balance of $10,000. Let’s also say you happen to have $10,000 sitting in the bank. In this scenario, it probably makes sense to just pay off the car loan. You just want to make sure you have a little cushion in terms of an emergency fund.
I know some will argue that you shouldn’t pay down debt like this until you have six months of an emergency fund. But in this scenario, you are wiping out your car payment. If the monthly payment was $400 per month, then you just increased your cash flow each month by $400. It should help you to build yours savings back up quickly. And if you do have an emergency, at least you will be $400 better off each month.
Some will also argue that it depends on the interest rate. While the interest rate is not irrelevant, I don’t think it should come into play that much. Obviously if you have a zero percent rate, then you should probably just keep making the monthly payments since it is not costing you any interest at that point.
Even if your loan interest rate is 1.9%, it may still make it worth it to pay it off. You aren’t going to earn that much interest in a bank account or money market fund these days. Therefore, if you have the money sitting in a bank doing nothing, you might as well save yourself the little bit of interest on the car loan.
Of course, I say all of this with the premise that you have no other debt except a mortgage. If you have credit card debt or student loan debt or something else, then that should probably take priority over your car debt.
If you are in a situation where you can pay down your car loan significantly but don’t have enough to pay it all off, then you are going to have to judge for yourself based on how secure you think your income is and whether you will need any of that money for an emergency. If you have a $25,000 loan with $10,000 sitting in the bank, you should probably just keep the money in the bank.
If you have $10,000 in the bank and a $12,000 car loan, then you may just want to wait a couple of months until you can pay the whole thing off. Again, you have to assess your own situation.
While paying off a car loan is not as big of an accomplishment as paying off a mortgage, it can still be liberating to a certain degree. It is one way to increase your monthly cash flow.