We just refinanced our house into a 15-year mortgage. We will be paying off our car loan early. The mortgage was 4% (now 3%) and the car is 2% interest. The math says that it’s usually better to invest your money than to pay off low interest loans. So what the hell are we doing?
First a Little Math…
Say I buy a car and finance $15,000 for 3 years with a 2 percent interest rate. Using an online car loan amortization calculator I see that I would pay a total of $467 over the loan term. If I paid the car off in 5 months, then I would only pay $118 in interest, saving me $348.75. It would take approximately $13,000 to pay off the current remaining balance. This results in a return on investment (ROI) of $348.75/$13,000 = 2.67 percent.
Not very impressive.
On the other hand, let’s assume I had that $13,000 just sitting around and decided to invest it, say in an index fund in the stock market. I would then plan to leave that money invested for the 3 years. Assuming an average annual return of 6 percent (and in this fairy tale there is no market volatility) that money would be worth $15,483 for a gain of $2,483.
Well geez… $348 vs. $2,483? It’s clear to see why most folks would rather invest the money rather than pay off the loan.
So why again are we bucking the math?
Compounding is a Blessing or a Curse
As investors the power of compounding is one of the wonders of the world. It has the ability to dramatically inflate small amounts over time. But conversely, when compounding is going against you, like with a loan, it can mean that a small loan balance just won’t go away.
As a frugally-minded individual, the fact that we are paying someone else each month to borrow money just clashes with my personality. We fought a long battle to free ourselves from consumer debt and the fact that we’ve taken on more creates anxiety. Ain’t nobody got time for that!
More Cash Flow
Paying off the car frees up a nice chunk of change for us each month, around $460. With a bigger gap between our income and expenses we are better able to tackle unforeseen expenses. You know… water heater goes out, car breaks down, someone gets sick… that sort of fun activity.
Additionally, more cash flow means we can react quicker to opportunities and as priorities shift we can quickly adapt and redirect savings as we see fit.
Lower Monthly Expenses Means a Lower Financial Independence Number
Here in the Financial Independence Retire Early (FIRE) community, we often define our Financial Independence (FI) Number as 25 x our annual expenses. Meaning that once we have assets such as mutual funds equal or greater than our FI Number we can essentially retire. Having a car payment of $460 a month ($5,520 annually) means our FI Number needs to be $138,000 higher than compared with not having the car loan. That could easily be a couple years or more worth of savings. That’s nothing to sneeze at.
Lack of Attractive Alternatives
If we didn’t drop the lump sum to pay off the loan, where else would we use it?
By most accounts the stock market has been priced very high recently. While we still aim to max out our 401k, and other tax deferred investment options, it seems that annual returns will likely be lower than we’ve been accustomed too until valuations normalize. As I write this the market dropped 800 points today. Is it a “healthy correction” or a sign of a recession? I, for one, have no idea, but volatility seems to be on the menu for the near future. As a result, investing a lump sum into a taxable brokerage account does not seem attractive right now.
Another alternative that I’ve been eyeing is real estate, specifically buy and hold. However, our local market is very frothy with demand seemingly outstripping supply. I have family looking to purchase in our area and it’s quite common for properties to go over asking price on the first day of listing. When looking to invest in real estate it is critical to buy at a discount and I am not seeing much out there right now.
The Math Part II
I laid out in the example above how NOT paying off the loan would be more than $2,000 better than paying it off. But what if I told you that the math can actually favor paying off the car now?
Think longer term. Financial Independence is probably 10 to 15 years off for us. We don’t plan to touch our savings before then. When you inject several years into the equation the math swings around. Here’s how:
In the previous example the calculation doesn’t factor in what is done with the freed up cash flow once the car loan is paid off. Let’s say, I invest the former monthly payment ($429.64), which is now free cash flow, into an index mutual fund with the same average annual return of 6 percent. After 10 years I would have $70,409.12.
On the other hand, say I invest the $13,000 immediately into the same index fund. I make no further contributions during the 3 year loan term. Once the loan is paid off, I redirect the former monthly payment into the fund. After a decade I would have a fund balance of $69,153.
In this scenario the Pay Off the Car Now option wins by $2,879!
While it’s true that the ROI for paying the loan of now would be 40 percent vs. 41 percent for not paying it off, it needs to be said we are using the same money, so ROI is a misleading metric here. In fact, I tested average annual returns and found that it took a return of 21 percent for the Don’t Pay Off the Car option to prevail.
Kinda crazy.
The mental benefits of eliminating debt, along with the increased flexibility and reduced expenses alone make paying off the low interest debt very appealing. To see the math actually work in our favor is icing on the cake.
This is yet another reason to not take everything you hear at face value. Test the concepts. Run the numbers. Listen to what your gut and conscience tell you. You just might find it goes against the conventional wisdom.
