Strategies for Wealth Creation and Financial Freedom

Should I Pay Off My Car Loan? You Decide!

I’ve never carried a balance on my credit card. I paid off my undergraduate student loans in a mere five years. I bought my first new car – a 2008 Hyundai Sonata – with cold, hard cash, spurning the high-interest car loan offered to me by the dealer. Needless to say, I hate debt.

Now, my husband and I are in the position to pay off my loan on our second vehicle – a 2008 Hyundai Santa Fe. In a perfect world, we would have never bought the vehicle to begin with. We’d just purchased the Sonata eight months earlier and owned my aging Infiniti G20t outright, thanks to a generous graduation gift from my parents. But when the Infiniti required three major repairs back to back to back, we declared it a money pit and – thanks to the government’s Cash for Clunkers promotion – headed back to the dealership.

We were unprepared. We arrived on the showroom floor without prearranged financing through our preferred lender, putting us at the mercy of the dealership’s financing department. And yes, while we drove off the lot in a great car at a great price, we also ended up with an interest rate far higher than either of us would have liked.

This month marks three years since that day. And now, we’re ready to pay off that car loan. The question is, should we?

The Case For Paying Off My Loan

Our home is currently on the market, and we’re actively looking to upgrade to a larger home in the same area. Tomorrow, we go to the bank to finalize our mortgage preapproval for that new house. My husband is confident we’ll get the numbers we want; I, on the other hand, am not so sure.

I’ve done the calculations; I’ve seen the debt-to-income ratios; I know where we fall. The home we want to buy would put that DTI ratio near the top of our lender’s “OK” range of 38 percent:

MY INCOME

  • My husband: $2800 a month (gross)
  • Me: $1400 a month (gross)
  • Total: $4200 a month (gross)

MY DEBTS

  • Desired mortgage: $1200
  • Student loans: $140
  • Car loan: $260
  • Total: $1600

Doing the math, our monthly gross income divided by our monthly debts is 1600/4200, or just over 38 percent. Even if the bank does preapprove us, they may not give us the lowest interest rates available for our mortgage, dramatically increasing the loan’s total amount over the 30-year term.

But by eliminating my $260 monthly car payment, I’d reduce my debts to just $1340 a month, bringing our debt-to-income ratio down to a very manageable 32 percent – well within the bank’s parameters and, likely, securing us the lowest mortgage rates out there.

The Case Against Paying Off My Loan

Sounds like I should be writing the check to pay off my car loan, right? Well, not so fast.

Right now, the total owed on my car loan is $9504.12. We have the cash on hand to pay it off, but – if we did – it would dramatically cut down on our potential down payment for that new house. Using a mortgage calculator, I did the math:

  • Assuming a four percent interest rate on a $200,000 mortgage over a 30 year term, our monthly payments would be $954 (plus escrow); over the life of the loan, we’d pay about $143,700 in interest.
  • Assuming that same four percent interest rate, but this time on a $190,000 mortgage over a 30 year term, our payments would be $907 a month (plus escrow); we’d pay $136,500 in interest over the life of the loan.

The roughly $10,000 we’d use to pay off my car loan would increase our mortgage payments by $47 a month; it would add $7,200 in interest payments over the life of the loan.

Another factor going against paying off my loan? I only owe 38 more payments. At $260 a month, that brings out the total $9,880. Paying off the loan now would save me less than $400.

The “For” Side’s Rebuttal

However, if the lower debt-to-income ratio did mean the difference between, say, a 3.75 percent interest rate and a 4.75 percent interest rate, the numbers would be very different:

  • Assuming a 3.75 percent interest rate on that $200k mortgage, our monthly payments would be $926 a month with $133,400 in interest over the loan’s life.
  • Assuming a 4.75 percent interest rate on the $190k mortgage, our monthly payments would be $991 a month, with $166,800 going to interest over the life of the loan.

If, in fact, the lower DTI gave us an ideal interest rate, we could see that $9,500 payoff result in a savings of $65 a month, with a total savings of $33,400 in interest over the life of our mortgage. On top of that, we would be able to immediately put an additional $260 a month back into our savings account.

The Verdict

I am leaning heavily toward paying off my car loan, but I’m open to hearing from the Devil’s Advocate, so…

Readers, what’s your advice? Should I pay off the loan, or hold on to the money for a down payment on our new home?

2 Responses to Should I Pay Off My Car Loan? You Decide!

  1. I would hold the money. But that’s just because that’s what I’m doing right now. My car loan is 4.99% and we really want to buy a house sooner rather than later – the interest on a house will accumulate much faster.

  2. I wouldn’t pay off the car loan just yet. Unless you’ve talked to lenders and they tell you that you should pay off the car loan before you can get a loan, then there’s no reason to jump to hasty conclusions. My mom just went through this for a refinance and they told her that she should pay a few thousand on her car loan in order to get the car debt below $5000 – and that’s what she did. You may not need to pay off the entire thing just yet.

Leave a reply