This was a question addressed in a recent discussion I saw on Facebook.  It was not a random discussion amongst friends, but a conversation in a group that specifically discusses topics on financial independence.

The original person asking the question was wondering what to do with some extra money.  Should he invest it or put it into an emergency fund?  His only major debt is a car loan with a low interest rate.  I think it was 2.9%, but it could have been 1.9%.

There were varying opinions on the matter, but a few people (including myself) suggested paying off the car loan early.  There were some who vehemently disagreed because of the low interest rate, including the original commenter asking the question.  When these discussions form, it goes from giving advice to the original commenter to having a general philosophical debate.

I want to address why it might be a good idea to pay off a car loan in such a situation, even with a low interest rate.  I personally did this years ago on my car, even though my rate was really low.

Several years ago, I wrote a report on the pros and cons of paying down your home mortgage.  It is still available on kindle, and it is still very relevant today.

One of the cons of paying down your mortgage is that you are locking up your money.  Unless you sell your house or refinance it, that money you put into the principal balance of the mortgage is unavailable.  Therefore, if you are going to consider paying down your mortgage, you definitely want to have a substantial emergency fund beforehand, at a minimum.  The one exception is if you could actually pay off your mortgage because at that point you would start reaping the gains of not having that payment every month.  But even in this situation, you would still probably want to have some money in reserves for emergencies.

In my personal case, I did not have near enough liquid funds to pay off my mortgage.  Therefore, I haven’t touched it.  But I did have enough to pay off the remaining balance on my car loan.  So even though the interest rate on my car loan was lower than the interest rate on my mortgage, I opted to pay off the car loan, given that I did not have any other immediate uses for the money except possibly conventional investing.

As soon as a I paid it off, I didn’t have the car payment each month.  This was an immediate benefit for cash flow.  It made sense.

That is why it often makes sense to attack a car loan, even at a low rate.  It is much more feasible for most people to pay off the car loan in its entirety, thus eliminating that monthly payment.

If you have an emergency fund of $20,000 and a car loan with $15,000 remaining, then it might make sense to pay off the loan, even though your emergency fund would shrink to $5,000, assuming you don’t have any other known big expenses on the horizon.  In this scenario, you can divert the money that you would have been paying monthly towards your car payment back into your emergency fund.  You should be able to replenish your emergency fund within a few years just with the car payment money.

This isn’t always a good idea for everyone, and you certainly have to take your own personal situation into account.  Someone with higher expenses due to a family may want to have more of a cushion, for example.

As far as investing goes, it is true that you may be able to get a much better return on your money than the interest rate on your car loan.  But maybe you won’t.  Unless you can find a U.S. government bond paying a higher rate than that (which you probably won’t), then you will have downside risk to your investment.

While 1.9% or 2.9% isn’t a high rate, it is very difficult to find a risk-free return higher than that.  And depending on your tax rate, you may have to earn close to a 4% return just to get that 2.9% after taxes.

It is obviously a personal choice based on your risk tolerance.  It is also an issue of opportunity costs.  But unless you feel confident (and that doesn’t always mean anything either) that you can get a significantly higher return than the interest rate on your loan, why not lock in the sure thing?