Table of Contents
In a previous article (‘Reasons to Pay Off Your Car Loan’), I discussed the reasons it may be beneficial to pay off your car or vehicle loan. But it may not always be the best idea. There can be advantages, particularly in certain economic environments, where it can make perfect sense to hold on to that car note even if you have the money to comfortably pay it off. There are always two sides to every coin and that certainly applies to whether to pay off your car, truck, boat or whatever you have that gets you from one place to another.
Reason #1: Your interest rate is below the rate of inflation
So, this is an easy one. If the interest rate on your car loan is below the current inflation rate, then you would be effectively losing money by paying off your vehicle. Your money would be worth more doing something, likely anything, else.
For example, if the interest rate on your car loan is 0% and the inflation rate is 2% then you would be better off putting your payoff amount into a savings account… even if is a tiny sum. The small amount earned in a low yield savings account would be larger than the 0% interest being paid on your current principal. If your loan rate is above 0% but still below the rate of inflation, things can get a little dicey but suffice it to say that if your rate is below the rate you can earn from a savings account then not paying off your loan can make sense.
This does not mean that you should invest your payoff sum in the stock market. That would be ignoring the risk involved with making such a decision. Rather, placing your payoff sum in a CD or bank savings account that is insured by the Government (FDIC) and earning a small sum is a relatively safe alternative. Keep in mind, this article is only considering a very narrow ‘pay off or not scenario’ that does not consider your overall financial situation or risk tolerance.
How do I find the current rate of inflation?
The easiest way in the United States to determine the current rate of inflation is by checking with the U.S. Bureau of Labor and Statistics. They publish a monthly figure called the Consumer Price Index (CPI) here. Use the CPI number for the category labeled ‘All Items’ to approximate the rate of inflation. This number could be used for the above example when trying to determine whether to pay off your vehicle.
Reason #2: You are trying to build your credit
Another reason that might lead you towards thinking twice when paying off your vehicle is because you are trying to establish or build your credit score. A better credit score will lead towards lower borrowing costs and possibly insurance premiums in the future. The more times you show that you can pay a fixed amount over a period of time without missing a payment or defaulting will usually lead towards a higher credit score (although, there are a number of other factors that may change it as well).
Building Credit: Young and have a Short Credit History
The younger you are, the chances that you have a significant credit history to prove you are trustworthy lowers. Thus, having a reasonable car payment each month may be a good way to build that history. This can lead to a higher credit score and may set a young borrower up for a better rate or loan terms when it comes to buying their first home in the future.
Building Credit: Have a tarnished record and looking to recover
If you are recovering from circumstances that have may have led to a poor credit history then keeping your current car payment in place may be a good choice. The more time you can put in between now and a missed payment, default, or bankruptcy the better. Showing you are a better borrower is always possible by paying your current vehicle’s note on time.
Reason #3: You are looking to buy a different vehicle or car
If you are looking to sell or upgrade your current vehicle, it may make sense to hold off paying off your car. Once you pay off your vehicle it may take time for the lending company or bank to send you your title depending on the laws in your state. If you are about to walk into a dealership and are looking to trade in your vehicle, they may want clarification on who has the title and how much is owed. Being in the middle of this process will likely delay or complicate your ability to complete the transaction.
Reason #4: You don’t have an adequate Emergency Savings
Paying off your vehicle requires money. Who knew? But usually, if you are in the middle of making payments on your vehicle, then the total payoff amount is likely a much larger sum of money than the monthly payment. If you don’t have an amount set aside for emergencies, then you shouldn’t place paying your vehicle off at a higher priority. Take that sum of money and put it into savings.
Having an emergency savings is key to living a fruitful financial life. The ability to make financial decisions without emotion or desperation is a powerful tool. To do this, many experts recommend you put anywhere from 3 months to 9 months’ worth of expenses into an account that has a low risk of loss (think FDIC insured savings account). Once you have done this, then it may be time to pay off your vehicle… but not until this task is complete.
Reason #5: You live on a fixed income
Living on a fixed income may present an interesting challenge (or opportunity!) when it comes to paying off your vehicle. If you should decide to pay off your vehicle early, something psychological happens. You will have a hole in your budget and nothing to spend it on. With a disciplined approach, investing this money or putting it aside in some other way may be smart. But we are all human, and if lifestyle creep sets in then you may find yourself, years down the road, having a hard time adjusting back down to the lifestyle necessary to either get a new car or conduct necessary repairs on the one you have now.
Keeping a fixed payment for your vehicle may be preferable to paying off your loan if you have a hard time saving money. This is not meant to be a knock or low blow, rather, it is important for you to understand yourself to be ultimately successful. If you know that at the end of the month that money burns a hole through your pocket, then you should consider not paying off your vehicle and keeping that payment ongoing. If you have an additional amount sitting around now, then beware! Get it somewhere where you can’t spend it quick like an investment account that doesn’t have a debit/credit card.
Reason #6: You have other loans or bills that have higher interest rates
This reason is much like the first reason. If you have another place you can put your money that may result in higher (generally safe) returns then you should put it there. This means that if you have other loans outstanding that have higher interest rates such as another vehicle or credit card debt then you should consider paying those off first.
For example, if I have 2 cars and I owe $10,000 on both and one has a higher interest rate than the other, then paying the one off with the higher rate will lead to lower overall balances (good). In essence, I will be paying more in principal than interest each payment reducing the overall amount I will pay in the long term. If I can pay off worse debt (higher interest debt) then that should be preferred instead of paying off the vehicle or car loan.
Conclusion and Financial Warning
These are all reasons to consider not paying off your car. For reasons to consider paying off your vehicle then please check out my article entitled ‘Reasons to Pay Off Your Car Loan.‘ Please remember that I write this blog as an individual looking to share to my own thoughts and opinions. For your own financial situation, you should look for advice tailored towards your individual financial reality. I would recommend talking to your Certified Financial Planner or Accountant.