Paying off loan can limit flexibility

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Dear Dr. Don,
My husband wants to cash in a $25,000 CD to pay off an auto loan of about $23,000. We are in our late 50s. We have some money in pension plans and invested in
401(k) plans. We would not have six months of emergency funds if we go ahead with this plan.

The auto loan is at about 7 percent and the CD is paying roughly 4 percent. We are in disagreement about how to handle this situation. Please help give any advice you can on this topic.

Debra Dénouement

Dear Debra,
It’s not an easy choice.

My rule of thumb is that it can make financial sense to repay the loan from savings if you expect to earn less on your savings after taxes than the after-tax cost of the loan. The more conservative your investments, the more likely it is that you’re earning less on your investments than you’re paying in interest.

However, cashing in savings reduces your financial flexibility. So, it may not make sense.

Financial planners typically recommend three to six months of living expenses for an emergency fund. You’re on the high side of that. One reason to be on the high side is that, in your 50s, a career search can take longer and you could use that extra cushion if one of you loses your job.

A compromise, if you are homeowners, could be to take out a home equity line of credit to act as a financial safety net. The HELOC could replace some of the money in your emergency fund. It’s not a perfect solution because of closing costs and any required initial draws on the line, but you can make it work.

Paying a penalty for early withdrawal on the CD or a prepayment penalty on the car loan would skew the decision against paying off the loan.

Another key variable is to determine what you’ll do with the money that now goes to the car payment. Investing it will build up your reserves. Spending it increases your current living standards but doesn’t do anything for your future.

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