Should I Pay a Loan Off Early?

Dear Jim,

I have a 5 year loan for a vehicle that I took out 4 1/2 years ago.  I have 6 months  left to pay and the balance is just over $2400.  The interest rate is 7.75%.  I also have $3000 in cash that I am thinking about investing.  Should I invest it or should I pay off my car loan?

A friend told me that I’ve already paid most of the interest on the loan and that, from this point out, it’s not worth paying off since I’m pretty much just paying principle at this point.

Chuck

Chuck, your friend is both right and wrong.

Assuming you haven’t made any extra payments along the way, it looks like you borrowed about $24000 to purchase your auto.  Over the past 54 months (4.5 years), you have paid about $5000 in interest.  But, if you keep the loan and finish making the payments over the next 6 months, you will only have to pay $65 in interest.  Your friend is absolutely correct that you have already paid the majority of interest on this loan.

However, it’s probably best to pay off the loan now.  Here are explanations of your two options:

  1. Pay the loan off now.  You will save $65 in interest.  Over the next 6 months, you can save ~$500 each month instead of making payments.  You’ll have $3000 in cash in 6 months that you can invest.  Even if you don’t get any interest on your savings over the next 6 months, you will have saved $65 in interest.
  2. Keep making payments and invest your $3000 in a safe investment like a CD.  You’ll pay $65 in interest on the loan.  If you look around carefully, you should be able to find a CD that pays 0.5% interest.  Bankrate.com can help you find the best CD rates.  But, at 0.5%, your CD will only provide you with $7.50 of interest income.  Depending on your tax situation, you could pay up to 26% tax (15% Federal plus 11% state if you live in Oregon or Hawaii) on this interest income.  At the end of 6 months, you will have $59. 45 less in your pocket.

It’s clear that the first option is usually better.

One exception may be in the case where you are among the 28% of Americans without emergency savings.  If you have no savings, it may be advisable from a psychological perspective to start building an emergency fund rather than saving the $65 by paying off the auto loan early.  You’ll still have $65 less at the end of 6 months.  But, often, people find it easier to borrow money rather than give up savings.  If you have savings, you’ll carefully think before you dip into it.  With no savings, however, it can be more tempting to label purchases as “emergencies” and charge them to a credit card.

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