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A hypothetical friend of mine is very young (22 y.o.) lives in the US and has no other debt except a recent 5 year 3.5% interest auto loan.

His monthly payment is around $300

He is maxing out his matching portion of work provided 401(k) and makes some contributions to his Roth too (far from maxing it out, 30% of max allowed amount).

There are three scenarios that

  1. Pay twice as much monthly (he can easily afford this) towards the car and get rid of this debt super soon.

  2. Pay required amount for car and max out Roth in addition

  3. Keep $300 for 10 month in a saving account and open an non-tax-sheltered index mutual fund account (let's say VFINX with $3k min at Vanguard). Pay normal monthly payment for the car and the same amount towards his mutual fund account. When the value of his investment exceeds the payoff amount for the car cash the fund and pay off the car. (he would wait a little longer to cover taxes on capital gains or just absorb 10-15% tax capital gains)

Which scenario makes the most sense ?

PS This hypothetical friend is a frugal person and lives way under his means with a thick cushion of emergency fund and no other debt of any kind besides a car loan)

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    Perhaps including a hypothetical annual income and hypothetical thickness of the emergency fund of your hypothetical friend would help people to construct reasonable answers. – Dilip Sarwate Jan 8 '15 at 12:37
  • let's take $50K as an annual income and $10k as a liquid emergency in savings. – AstroSharp Jan 8 '15 at 15:42
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    You are making up a friend with a hypothetical scenario? Why not just have your own scenario? – JoeTaxpayer Jan 8 '15 at 21:01
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Thanks for your question. Definitely pay the car down as soon as possible (reasoning to follow). In fact, I would go even further and recommend the following:

  1. Reduce the emergency fund to a much smaller amount (say $1,000 for example), and use this to pay down the car loan immediately.
  2. Direct 100% of monthly free cash flow toward the remaining portion of the car loan until it is eliminated (this should be able to be done very quickly)
  3. Direct a portion of that free cash flow toward saving for the next car, so that you are on track to pay for the next car in cash. This money could be invested in a way that is appropriate for a short-term timeframe.
  4. Use remaining free cash flow to rebuild the emergency fund to a comfortable level (perhaps 3-6 months of living expenses).
  5. Begin/Resume investing in the Roth.

Why?

1) Make money risk free - the key here is RISK FREE. By paying down the loan now, you can avoid paying interest on the additional amount paid toward principal risk free. Imagine this scenario: if you walked into a bank and they said, "If you give us $100, we'll give you $103 back today", would you do it? That is exactly what you get to do by not paying interest on the remaining loan principal.

2) The spread you might make by investing is not as large as you may think. Let's assume that by investing, you can make a market return of 10%. However, these are future cash flows, so let's discount this for inflation to a "real" 8% return. Then let's assume that after fees and taxes this would be a 7% real after-tax return. You also have to remember that this money is at risk in the market and may not get this return in some years.

Assuming that your friend's average tax rate on earned income is 25%, this means that he'd need to earn $400 pre-tax to pay the after-tax payment of $300. So this is a 4% risk-free return after tax compared to a 7% average after tax return from the market, but one where the return is at risk. The equivalent after-tax risk-free return from the market (think T-Bills) is much lower than 7%.

You are also reducing risk by paying the car loan off first in a few other ways, which is a great way to increase peace of mind.

First, since cars decline in value over time, you are minimizing the possibility that you will eventually end up "under water" on the loan, where the loan balance is greater than the value of the car. This also gives you more flexibility in terms of being able to sell the car at any point if desired.

Additionally, if the car breaks down and must be replaced, you would not need to continue making payments on the old loan, of if your friend loses his job, he would own the car outright and would not need to make payments.

Finally, ideally you would only be investing in the market when you intend to leave the money there for 5+ years. Otherwise, you might need to pull money out of the market at a bad time. Remember, annual market returns vary quite a bit, but over 5-10 year periods, they are much more stable. Unfortunately, most people don't keep cars 5-10+ years, so you are likely to need the money back for another car more frequently than this. If you are pulling money out of the market every 5-10 years, you are more likely to need to pull money out at a bad time.

3) Killing off the "buy now, pay later" mindset will result in long-term financial benefits. Stop paying interest on things that go down in value. Save up and buy them outright, and invest the extra money into things that generate income/dividends. This is a good long-term habit to have. People also tend to be more prudent when considering the total cost of a purchase rather than just the monthly payment because it "feels" like more money when you buy outright.

As a gut check for whether this is a good idea, here is an example that Dave Ramsey likes to use: Suppose that your friend did not have the emergency fund, and also did not have the car loan and owned the car outright. In that case, would your friend take out a title loan on the car in order to have an emergency fund? I think that a lot of people would say no, which may be a good indicator that it is wise to reduce the emergency fund in order to wipe out the debt, rather than maintaining both.

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    He can put the emergency fund into the Roth IRA, because contributions can be withdrawn at any time without tax or penalty. – user102008 Jan 12 '15 at 6:59
  • @user102008 Thanks - I just don't generally recommend putting money into the stock market unless you're ideally going to leave it there for a while. – JAGAnalyst Jan 12 '15 at 17:25
  • Well, the stuff in the Roth IRA don't have to be in the stock market. He can just invest it in whatever he would otherwise have invested that money in. – user102008 Jan 12 '15 at 18:28
  • @user102008 This is true of the contributions, but you still pay taxes (and possibly penalties) on what you've earned on your contributions in this scenario. It's after tax, so there doesn't seem to be a reason to put it in a retirement account. Emergency funds should be liquid and not at risk since they are not investments. – JAGAnalyst Jan 12 '15 at 18:45
  • Right, but contributions come out first, so as long as you don't take out more than your contributions, there is no tax or penalty. Your contributions don't decrease, so there is that much money that you know you can take out at any time without tax or penalty. The reason to put it in is you get to hedge it both ways -- you can take it out without tax or penalty if the need arises, and it grows tax-free if the need doesn't arise. The money in the Roth IRA can be put in a risk-free or risky account, or combination thereof. – user102008 Jan 12 '15 at 19:56
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Scenario #2 is most likely will generate the best long-term financial outcome. If your friends emergency fund is truly excessive and can afford to be reduced by the amount required to payoff the vehicle loan then that will save a few dollars.

Scenario #3 is not an approach I would recommend.

However, if your friend has to choose between paying off the loan or maxing his Roth...

Making a few assumptions regarding the loan, I figure it is probably a 4 year - $13.5k. Which means he is paying somewhere below $40 a month in interest. As JAGnalyst speaks to people often over estimate the spread they can make with another investment compared to the interest rate on a loan. However, the effect of compounded, tax-free returns can not be ignored when you are discussing a 22 year old person contributing to a Roth IRA.

Doing some calculations, assuming the car is being paid off on the first payment your friend will save just under $1000. The total interest that would have been paid over the life of the loan.

If your friend adds $3600, approximately one year of payments, to their Roth IRA contributions -- just once. Assuming a 3.5% avg return and a retirement age of 65, the $3600 will be worth just south of $16k; a $12,400 return.

Using the same investment return and tax assumptions and simplifying the $1000 savings as if it was all realized as a lump sum at the time of paying off the loan. That $1000 invested in a non-tax-advantaged investment (because the whole discussion is based on if the friend had to pick and lose the opportunity for the one year to make the additional Roth IRA contribution) would return $3047.

  • Now compare the net present value of the $1000 now vs. the $16k later. – Nathan L Jan 8 '15 at 22:48

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