Pay off the car or invest?

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halcyon
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Postby halcyon » Tue Dec 14, 2010 7:09 pm

My car died recently (rest in peace) and we ended up buying a used car.


Here are the loan details:

17.8k balance, 2.75% interest, 4 year term, $392/mo payment


We've been discussing what we should do about it and we've basically come up with two options: pay it off in 8 months by diverting some investment savings or pay it off in 4 years.


The difference in interest savings would about be about $1k if we payed it off in 8 months.


We invest in real estate and the difference between the two scenarios is about 1 house, or $200/mo in passive income. Additionally, there is a certain, hard to quantify, psychological benefit in paying off the loan quickly.


Any thoughts? Either plan will start in january since we have already accounted for every dollar this month.



AlexOliver
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Postby AlexOliver » Tue Dec 14, 2010 7:40 pm

What return would you be making on the investments? Unless you're pretty incompetent, you should make more than 3%, making investing the smarter financial move.


wrt the psychology of it all, the only person that can give you that answer is yourself.



George the original one
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Postby George the original one » Tue Dec 14, 2010 9:20 pm

Since the interest rate is low, I'd go with the investing, though I'd keep it in a liquid account rather than real estate.


The caveat is that the investment return (at my 34% state & fed tax rate) has to be at least 4.3% pretax to make any headway and preferably above 5%... since my own yield is about 6.5%, I would be comfortable investing.



M
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Postby M » Tue Dec 14, 2010 9:20 pm

Another expense associated with having a car loan on a car is that you have to carry full coverage insurance on the car. Depending on the car and driver, etc, this can be pretty expensive. If you pay off the car, you can get liability insurance and avoid this extra monthly charge.


Since the interest on your car loan is so low, however, I would only pay off the car early if the amount of money you can save by switching to liability insurance combined with not having interest charges is greater than the lost investment income you would have had. I don't know what you pay for car insurance, so I can't really give you an answer to this question.


As far as the psychology aspect of it goes, I've found that I sleep better at night when I don't owe anyone money on anything that is 'mine'. Your results may vary, however.



KevinW
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Postby KevinW » Wed Dec 15, 2010 4:26 am

Comparing interest rates is a good place to start, and I agree with George that you're probably better off investing even factoring in taxes.


However you should also consider cash flow. If you pay off the debt, that monthly payment disappears which gives you greater flexibility and makes you less vulnerable to income disruptions. Usually it only makes sense to make long-term investments when you are certain you won't need to liquidate them for many years. So I would also look at your income security, cash reserves, and other recurring expenses to make sure you're at that point.



jacob
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Postby jacob » Wed Dec 15, 2010 6:20 am

Interest rates are currently low---real yields may be close to negative. Earnings yields on stocks are historically low. Real estate is probably still overvalued (doesn't mean it can't bear rally).


I'd pay off the car. Consider in particular if anything, anything at all, could happen which would cause you to miss the car payment.



Mo
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Postby Mo » Wed Dec 15, 2010 4:03 pm

Unless you're good at investing, and/or have some ability to invest your marginal dollars in a

tax-advantaged way, it seems unlikely that investing will really generate you much money. Your numbers, though, suggest that you are exceptionally good at investing, and can turn less than $17,800 into an income of $2400 per year. That's at least a return of 13.5%. If you can regularly earn a return of 13.5%, reading my comment is a waste of your time.


Your scenario involves paying off the loan quickly vs slowly, and also the factor that some of your money would allow what appears to be a leveraged real estate investment. Without all of the details, it's hard to compare the two scenarios you have mentioned.


Perhaps this scenario will be helpful in your decision making: imagine you have both $17,800 in cash, AND a reliable post-tax cash flow of $392/mo for the next four years. The choices then are A) Pay off the car with the $17,800 in cash, and invest the $392/mo for the next four years. or B) Invest the $17,800 now and use the $392/mo to make the car payments.


Imagine that you could earn 6.5% like George, and that you are also subject to a marginal tax of 34%. Over the 4 year term, you might end up with around $604 total additional money with choice B (A=20,453, B=21,057). Naturally, if you can earn greater than 6.5%, or pay less than 34% in taxes, you'll end up with more money. If you factor in the insurance savings described above, you'll end up with less, etc... We also haven't factored in inflation, and that is an incredibly interesting, but complex consideration that is highly dependent on the individual.


These questions of pay now vs. invest and borrow come up a lot. The standard response is to quickly consider the difference in the loan interest rate and the pre-tax investment return rate and punch out a quick answer. Minimal consideration is given to the real, post-tax difference in wealth at the end of the two scenarios.


Generally speaking, for amounts under $50k, terms under 7 years, and differences in interest vs return of less than 5% (without accounting for taxes), usually the answer is: it doesn't really matter. How much effort/risk should a person with $18k in the bank and a $400/mo cashflow put into earning an additional $600 over four years? Lastly, issues of significant consequence are often entirely left out of the equation-- such as the insurance savings of paying off the car earlier.



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Felix
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Postby Felix » Wed Dec 15, 2010 4:31 pm

The safest route is paying off the car. The other option is basically gambling with borrowed money, which is something I would recommend against in principle.



dragoncar
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Postby dragoncar » Wed Dec 15, 2010 7:32 pm

Right, the question can equally be asked: Would you buy stocks on margin at 2.75% fixed? If so, why aren't you doing so already? Apparently interest rates are quite low.


I think investing the money is roughly equivalent (edit: to a margin scenario) , but someone let me know if my analysis is wrong here.



halcyon
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Postby halcyon » Wed Dec 15, 2010 10:06 pm

Thanks to everyone for their detailed replies and advice.


@AlexOliver My current rental property is yielding 17% cash on cash before taxes. I would consider this pretty average for my neck of the woods.


@M I hadn't considered the insurance costs but it seems that I have been paying for full coverage this whole time, even when driving my previous clunker. I will have to look into this in more detail.


@KevinW and @Jacob The cashflow perspective and the interest savings would be my primary motivation for paying it off. I feel pretty secure with my income(though perhaps i shouldnt) because my wife and I both work and we can survive on less than 1 of our incomes if one of us were to lose our job. I think the risk of both of us losing our jobs is pretty small.


@Mo I don't consider myself particularly skilled as an investor but I am willing to do what many are not (IE be a landlord). You are right that this would be a leveraged real estate deal but I never end up with less than 25% equity so its not over-leveraged (in my opinion). Your analysis is very interesting and I will have to go back and run the numbers again, this time with consideration for taxes and compounding which i had basically ignored in my 10 minutes of spreadsheeting. Here, the difference between return and interest rate is pretty large so i'm leaning towards investing.


@Felix While i agree that paying off the car would be safer, I'm not sure that I agree with your opinion that investing the money would be gambling with borrowed money. If that were the case, should i then pay off my mortgage before I invest? It would take me 3 years and lower my monthly expenses by about $600. With the same amount of money, i could go buy a 32 unit apartment complex... or at least partner up on one.


@dragoncar I guess in the RE scenario, this would be the equivalent to borrowing the down payment at 2.75%. If i could do that, I would do it in a heartbeat since i would still cashflow and would then have an infinite ROI.


Overall, I'm leaning more and more towards investing. By the time I ERE, the car will be paid off and so I can effectively ignore it when i consider my final ERE expenses. My wife and I would like to buy 3 houses next year and after running the numbers, we wouldn't be able to do that and pay off the car.



Mo
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Postby Mo » Wed Dec 15, 2010 11:41 pm

I'm not being sarcastic in this post.


Halcyon, good for you, man! You know, if you can pull in 17% on your rental properties before taxes, I'd bet you come out ahead by investing. Also, if you can add 2-3 homes per year at $2400 per year positive cash-flow-- you're golden. You'll be rich! To me, that kind of success seems like a pipe dream, but we all know that some people can do this, and it seems like you're one of them, congrats.


I know a lot of the people who read the forums have considered rental property as an investment, and people talk about it a lot here. Since you've had some success with it, I really look forward to seeing your comments as the threads happen.



halcyon
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Joined: Fri Dec 03, 2010 1:11 am

Postby halcyon » Thu Dec 16, 2010 5:07 pm

Thanks, Mo.

I'm still at the beginning of my investment career but I feel very confident that if i stick with it I will succeed. I will be starting a journal on here soon so watch out for that.


I'm fortunate because I have very good mentors and I live in an area where those kinds of returns are possible. I think there are only a few housing markets in the country that are as favorable as my area.



Matthew
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Postby Matthew » Thu Dec 23, 2010 1:22 am

It depends on how confident you feel your future paychecks will be. Pay off the car if you are not. Invest if you feel your position is secure. The additional spending in investing will keep you from spending else where.




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