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Dr. Don TaylorUsing savings to pay off auto loan

Dear Dr. Don,
We have about $14,000 left to pay on our 2-year-old car at an interest of 4.5 percent and about three years left on the loan. We plan on keeping the car till the wheels fall off. We have a total of about $17,000 in savings, earning 3 percent.

My husband and I both have good, steady jobs and no kids. The only other debt we have is a mortgage. Shouldn't we pay off the car? If we got into a bind, we could always sell it and "downsize." We were thinking about trying to pay it off in six months' time by making very large monthly payments in order to space it out a little.
-- M.L. Motors

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Dear M.L.,
You really don't have enough in savings to have it make sense to pay off the car loan. Taking your savings from $17,000 to $3,000 to pay off the car loan will save you some interest expense, but not as much as you think, and it's much smarter to keep the savings in reserve as an emergency fund. It's a good idea to keep three to six months of living expenses in liquid funds just in case you need to weather a financial storm. You didn't talk budget, but $3,000 isn't likely to be enough of a reserve.

Your idea of downsizing your car if you run into financial difficulty really doesn't make sense because you'll sell wholesale and pay retail on the exchange. Include the depreciation you'll experience on a new car and you're taking a pretty big financial hit just to free up the cash in your paid-up vehicle.

  Auto loan Savings Reinvest the loan payment
Loan balance: $ 14,000 $ 14,000 $ -
Remaining loan term (months): 36 36 36
Interest rate: 4.5% 3% 3%
Monthly payment: $ 416.46   $ 416.46
Total payments/value of savings: $14,992.45 $15,298.18 $15,667.34
Total interest expense/income: $ 992.45 $ 1,298.18 $ 674.89
Taxes on interest income (at 25 percent):   $ (324.54) $ (168.72)
Value of savings net of taxes:   $14,973.63 $15,498.62
Difference:     $ 524.99

As the table above shows, even though you're earning 3 percent on your savings and paying 4.5 percent on your loan, the loan balance decreases with each monthly payment so the remaining interest expense on the loan is less than the interest income on $14,000 of your savings. On an after-tax basis the interest earnings is within $20 of the interest expense on the auto loan. The table approximates your current situation from the information you provided, assuming a 25-percent marginal federal income tax rate.

Of course, the real key to evaluating whether it makes sense to pay off the loan is what you'll do with the money you free up in your monthly budget when you no longer have a car payment. If you don't take my advice and do pay off the loan instead, you should use that $416.46 each month to replenish your savings account. Do that over the next three years and you'll save the $992 in interest expense on the auto loan and earn about $500 after taxes on the savings. That will put you about $525 ahead of where you would be if you didn't pay off your loan early -- assuming you have the financial discipline to save the money.


 
-- Posted: July 15, 2005
   

 

 
 

 

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