retirement

Paying off car loan could backfire

Don Taylorq_v2.gifDear Dr. Don,
I'm pretty sure I know the answer to the question I'm about to ask, but to confirm, I'll ask anyway. My wife and I are both 30 and we have a 1-year-old child. We currently bring home about $110,000 a year. We have just over $60,000 in our 401(k) and 403(b) accounts.

We have two cars, one that will be paid off next month, and one that has about five years worth of payments left at about $420 a month, with an $18,000 loan balance. Other than our mortgage and a student loan with a balance of $22,000, we have no other debts. We are both contributing 12 percent of our salary toward our retirement accounts.

I would like to pay off my car ASAP so in the event that I lose my job, we can more than likely make due for some time. I've calculated that if I suspend my 401(k) contributions (not my wife's) and direct that money to my car -- and add to that what I've been paying on the other car, plus any extra money that comes in (like a tax refund) -- I could potentially pay off my car in 12 months. I would then resume my 401(k) contributions. Is that a bad idea?
-- Eric Earnest

a_v2.gifDear Eric,
In the current recessionary environment, I can see why you would want to be proactive in figuring out how you would meet your monthly expenses if you should lose your job. But if either you or your wife receives matching contributions to your retirement accounts, then at a minimum, you want to contribute up to the limit of those matching contributions. Don't leave that money on the table.

If both of you have the ability to borrow from your retirement accounts, it could make sense to keep contributing to the accounts and count on using a plan loan from the spouse who is still employed to provide a backstop if the other spouse gets laid off. Plan loans become immediately due and payable upon separation from service, so it's not a perfect solution if somehow both of you were laid off from your jobs.

What I don't like about your plan is how it's focused on the car payment. If you lose your job, there will be a lot of competing claims on your family's remaining income. Putting $18,000 aside in an emergency fund -- instead of using that money to pay off the car loan -- would give you a lot more flexibility if you should lose your job. You wouldn't expect to be out of work for five years, and when you found a new job you'd be able to resume paying your bills from income.

Money you contribute to your retirement accounts in your 30s has 30-plus years to earn a return that can help you meet financial goals for retirement. Stopping contributions because you might get laid off is a little too proactive for me, but I can understand why you want to make sure you can meet your current expenses during a time of financial duress.

If the plan loan option is a nonstarter for you, consider the emergency fund as an alternative to focusing solely on paying off your car.

To ask a question of Dr. Don, go to the "Ask the Experts" page, and select one of these topics: "Financing a home," "Saving & investing" or "Money." Read more Dr. Don columns for additional personal finance advice.

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