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:
- Reduce the emergency fund to a much smaller amount (say $1,000 for example), and use this to pay down the car loan immediately.
- 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)
- 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.
- Use remaining free cash flow to rebuild the emergency fund to a comfortable level (perhaps 3-6 months of living expenses).
- 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.
