Case Study: Should I Invest or Pay Down the Car Loan?

Check out this case study from Frank on whether he should invest or pay down the car loan and mortgage. Here’s the full email below. If you have financial questions for me, send them to [email protected] for potential inclusion in a Millennial Moola case study. 

Hi Millennial Moola,

For the last 2 ½ years I’ve been paying down my mortgage at an accelerated rate so I could get rid of the PMI and refinance my condo. I’ve recently completed the closing on my refinancing so I now have a 15 year, 3.5% mortgage. Given the tax advantages I no longer plan to pay down the mortgage at an accelerated rate and my condo has also appreciated in value so my equity position is pretty good. Given this, I’ll have an extra $200-$400 a month in free cash. My only other debt is my car note, which has about 3 ½ years left at 2.9% interest with around $22,000 outstanding.

Given I have the extra money, I’ve been thinking about using it to pay down my car note since I’m pretty debt adverse and because it’s a depreciating asset. That said, I also realize the opportunity cost of not investing the money in my brokerage account (who doesn’t like the idea of a 6-8% return with an index) might make paying down the car note a silly idea. What are your thoughts?

Here’s some other assumptions to help:

• My mortgage and property taxes are pretty small – it’s only like 11% of my gross pay (although I do have a condo fee that bumps that up to roughly 15%);

• I contribute around $560/month to my retirement plan plus I theoretically have a pension – if it’s not worthless when I retire;

• I contribute close to $550/month (sometimes more) to my savings and/or brokerage account already;

• The emergency fund I have is reasonable enough to get me by if I were to lose my job; and,

• My car note is my only other debt and my variable expenses are pretty low – I don’t eat out much and I don’t drink soda, coffee, or alcohol (you’d be surprised how much money I avoid spending because of these pesky vices).

So, what do you do you think: should I use the free cashflow to pay down my car note at 2.9% interest given my fear of debt, or should I lay my conservative nature aside and go with a possible higher rate of return in index funds ETFs and equities?

-Frank

Intro Thoughts on Whether Frank Should Invest or Pay Down the Car Loan

Frank seems to have a preference of paying down his 2.9% car loan versus paying down his 3.5% mortgage because of the tax benefits.  However, this is a common misconception a lot of middle class folks have about the value of their mortgage interest deduction. Let me explain.

I used bankrate’s online calculator to estimate the total interest cost in the first year of a 15 year, $200,000 mortgage at 3.5% and came up with about $6,270. To put it in context, the standard deduction is $6,300. If you are married, the standard deduction is double that. Unless you buy a huge house or have an enormous amount of itemized deductions to add onto your mortgage interest, you are unlikely to benefit very much from keeping your mortgage around. Even if you gave $6,300 to charity and the entire mortgage interest was deductible, if you make less than six figures, you barely come out ahead by keeping the mortgage around. The after tax effective interest rate would be 3.5% * (1-0.25) = 2.625% (because you are in the 25% tax bracket).

So before I address the broader question, first double check your taxes and make sure that you are actually itemizing. If you aren’t, the mortgage is more expensive and should be paid down first. Keep in mind the interest cost declines each year. As soon as you start using the standard deduction instead of itemizing, pay down the mortgage.

Now for the decision making. I have three options for how Frank could use his excess cash flow.

Rise Averse Option: Purchase Disability Insurance

Frank mentioned that he has a condo that only takes up about 15% of his paycheck. He probably makes about $100,000 based on this statement and his $560 a month retirement savings. I’m assuming he has a five year car loan since he mentioned having 3.5 years left on it. That $22,000 is a huge balance for a car and probably comes with substantial payments. Frank has substantial monthly expenses that could not be paid beyond a few months from his emergency fund or covered by Social Security disability payments.

Frank could purchase disability insurance to protect against the chance he would lose the ability to work and have to declare bankruptcy. With major monthly expenses like he has, he could lose his condo, his car, and the ability to pay for other pleasures in life.  Disability insurance costs about 3% of the income that you protect, with an acceptable range of 1% to 5%. If Frank chose this option, he should pay for a quality policy from an established insurance company that covers roughly 2/3 of earnings.

Medium Risk Option: Get Rid of the Car and Pay Down the Mortgage

That $22,000 car loan would make me worried as well. If the stock market tanked, the job market cooled, or an unexpected out of pocket expense happened, that car could be an anvil around your neck. I have heard that the majority of the happiness that a car brings is in the first few months of ownership. This might not be the case for you, but I felt like I needed to bring up dumping the car as a real option. Here is how I would do it.

You could build up savings in a traditional brokerage account or savings account for a car “loss fund.” You could use this money to get rid of the difference between what you would owe and what you could sell the car for to a dealer. Of course you could place an ad on cars.com and craigslist and try to get a higher price from a private party. I did this myself when I was trying to unload all my possessions to go to Europe. To be conservative though, I would use the dealer number just to make sure you are covered.

Frank pointed out that the car is a depreciating asset. If this is a sports car or truck, there is MAJOR depreciation left to go. Even if you sold the car at a $2,000 loss for example and repurchased a $9,000 Hyundai Elantra with low mileage, you would come out way ahead financially. You might hate your morning commute, but numbers wise you would be better off.

To figure out how much you would need to save to pay off the car loan if you had to unload it in a hurry, I’d take it to a local Carmax and get an estimate of what they would give you for it. Without the expensive car payment hanging over your head, your emergency fund would last twice as long in the event of temporary setback like sickness or loss of job. After the car was gone, Frank could take the extra money he has and pay his mortgage off in five years. The financial freedom of only have HOA fees and property taxes would feel really good emotionally and would protect him more in a financial crisis.

Risky But Mathematically Correct Option: Put the Extra Cash in the Stock Market

Frank sounds like he has a great job and kept the condo expense to an extremely reasonable percentage of his pay.  He already has an emergency fund, and the chance of him becoming disabled is far higher in his fifties than it is right now as a young guy. Even after adjusting for taxes, the expected return on the stock market over the next few years is about 5%-7%. This return easily beats the paltry 3.5% or 2.9% you would save on paying down your mortgage or car loan.

Using probability theory, the expected value of the stock market return is higher than the expected value of interest payments on debt, so the correct decision is to invest in stocks. However, this decision has the most downside. Realize this is like investing on margin, where your margin lending source is the lending institution that gave you your mortgage and car loan instead of your brokerage.

A Few Thoughts on the Next Few Years of Frank’s Financial Life

If it was me, I would try and sell the car and build up my emergency fund until I had a year’s worth of expenses in it. The car loan is not for $22,000. It is for what you could have in your brokerage account after 30 years interest if you did not own the car. After that, I would increase my retirement savings and add more money to my brokerage account in stocks. There is no right answer here because we are not math models, we are people with emotions and risk preferences. If you would sell all your stock if the markets dropped, then that changes the answer as to what would be best. I think from the level of financial knowledge Frank showed in his email, he can probably handle investing on his own.

I have a few things I would suggest Frank NOT do over next 3 years. Avoid upsizing to larger place at all costs. You got a nice condo, stay in it and build up 3 more years of equity. If you get married and move to a larger house, the goal would be to convert the condo to a rental with 100% ownership so the rental check is all gravy.

Also, do NOT buy a new car at end of car note term. You called out depreciation as being a big money loser, so is insurance, fees, repairs, etc. Your car note is large so I hope the car is fun to drive, makes you happy on your way to work, etc. If you love it, maybe make a goal that you will drive it for ten years.

Finally, do not invest in bonds. Debt is equivalent to a negative position in a bond. Why would someone buy Vanguard’s Total Bond Fund, which yields 1.96% as I write this, when they could earn a guaranteed return on their money by paying down their 3.5% mortgage? I just do not understand locking in negative interest payments every year just to have a larger portfolio balance on the asset side. I have a friend in the investment business who carried $30,000 student loans at 6% and invested in the PIMCO ETF at about 2.5%. I called him out on the massive guaranteed negative interest rate arbitrage he was inflicting on himself. He promptly paid off his loans with the money in this investment in his taxable brokerage account.

Frank can afford to have some nice things in life. He is in much better shape financially than the average American, much less the average American under 40. The expensive car could be a justifiable pleasure. Just make sure it is really worth the expense. If it is, then consider splitting the cash flow between your 401k and your brokerage to have a little bit more money in both accounts. In 3.5 years, you will be done with the car payments. At that point, just for peace of mind you might consider paying off the mortgage by putting the car payment money into extra principal payments. Good luck Frank!

If you as readers have suggestions for Frank, I’m sure he would love to hear them. Post in comments section below. Remember if you would like your financial question featured here on Millennial Moola, contact me at [email protected].