Don’t wipe out savings to wipe out debt

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Dear Debt Adviser,
I have about $9,000 debt on my car loan at 7 percent interest and $6,000 in student loans at 4 percent. I have about $5,000 in savings and I have the urge to pay down the debt on my car. My savings are in CDs, money market and statement savings accounts, but I don’t think I am making enough on them and feel it is best to pay down my car debt. I want to wait until I get my tax refund (if I get one) and add it to the $5,000. I might end up with $6,000 or more to pay down my car. My goal is to pay it off before July. I just need someone to tell me that what I am thinking of doing makes sense. Thanks.
— Kierrah

Dear Kierrah,
Your thinking makes perfect sense. You know what you owe. You know your loan interest rates. You have positive cash flow and you have a financial goal. Fabulous! You are absolutely on the right track. But please allow me to add to your thinking process a couple of additional considerations, based on my experience.

First, read the car loan document thoroughly to make sure there is no prepayment penalty clause. As the name of this clause implies, it penalizes borrowers who pay off their loans early. Lenders need to make a profit to stay in business, and when you took out the car loan, the lender expected a certain amount of total interest over the life of the loan. A prepayment penalty requires borrowers to pay some or all of that total interest amount, if the loan is paid off before a certain date.

I am so impressed that you have a stash of cash for a cushion. Next, I’d like you to think of at least part of this money as your emergency fund. If you use it all for the car note, you will have nothing to fall back on when an unexpected expense sneaks up on you. We don’t call it “emergency” savings for nothing.

Another thing, I didn’t hear you mention any money you put aside in your IRA. Yes, I know, you don’t plan on getting old and can’t imagine retiring ever and besides, that’s a hundred years away! Still, I want you to think about pointing some of your savings in that direction. The combination of youth and compound tax-deferred interest rates is impressive.

Assuming you do not have a prepayment penalty clause in your contract, here is my advice on some things you can do to pay off your car sooner without cleaning out your savings account.

First, figure out if you will be receiving an income tax refund. If so, putting some money in an IRA will increase your refund. File now so you can get that money out of Uncle Sam’s pocket and into yours. Filing electronically and opting for direct deposit can get you your refund in about 10 business days.

Set aside about two months of living expenses for that emergency fund. Over time you should grow the fund to six months, but I’d be comfortable with you having two months for now.

Next, with some bucks in the IRA and some allocated for emergencies, follow through with your plan — but only direct half of this money toward paying off your car. Keep the other half for you! A vacation. A trip home to see the folks. A small gift for your sweetie. There is nothing like some unallocated cash in your life to make it full of possibilities!

Next, look for places in your budget where you can shave expenses and target that money for the car note, too. You may have to revise your payoff date beyond July, since that date is already drawing near. Simple things such as brown bagging your lunch and using coupons at the grocery store can save more than you may think. Sell something you no longer use; if you have enough, hold a garage sale. Consider applying a portion of any new raise, promotion or bonus income to the car loan.

Having a goal will make it easier to focus for the time it takes to do this. Come July, I hope you will be well on the way to having a note-free car, with the rest of your life — financial and otherwise — in good balance and harmony.

Good luck!