Pay Off a Loan Early or Invest The Money First?
I’ve written before about choosing between paying off a loan early or investing the money. And I thought it’s worth revisiting that as I’m about to make the same choice myself.
A few years ago I got a car loan. However, I didn’t follow most experts’ advice. I did give a little bit more than the usually required down-payment and sought the lowest interest available. But I got a 5-year loan. That way I could get the lowest monthly amortization.
Most experts’ advice is to instead get the lowest loan total – that is, get the option that pays the least interest.
Not the most savvy move, specially for a guy with a personal finance blog. But sometimes numbers aren’t what they seem at first.
My choice afforded me some “extra” cashflow in my monthly budget – and in finance, healthy cashflow is always important. And this wiggle room in my budget allowed me to weather some surprises as well as the unavoidable growing expenses of starting a family.
And this is probably the first lesson I got from this experience. Yes, there was an “ideal” choice, but the more pragmatic one could work better.
I could have chosen to shorten the loan term and paid even more for the down-payment. But doing so would have caused a lot of stress and worry as my expenses unavoidably grew. And it would have left me vulnerable to some surprise expenses that came up.
Of course this “extra” wasn’t just extra spending money. They went to savings and investments. And now, I somehow have enough money to pay off the loan in advance.
Which brings up the first question: When taking out a loan, is it a good idea to keep some money in reserve? To invest it, grow it, and pay off the loan early?
I think the answer is Yes, but not for that reason. I found it helpful that I had an emergency fund to rely on. And that I could still add to it despite being in debt.
But if the extra money is in excess of my emergency fund I would rather have just increased my down-payment further. Or maybe take out a 3-year instead of a 5-year loan, if the extra money afforded that opportunity. I’d have paid less in interest to the bank while still getting a relatively low monthly amortization.
But now that I can pay off the loan early, should I?
In my previous post, I gave conditions and options. I could just invest the money in short-term time deposits. It made sense if I think about it. I can’t save money on the loan by paying early, but I can make a little extra money by investing the lump sum payment first rather than giving it to the bank. I still think that’s possible.
But that’s just the wrong move. Paying off the loan now ensures I own the car, gives me better cashflow immediately and, most importantly, affords me more choices.
By paying off the loan early, I can concentrate my time and money on my next goal instead of pursuing relatively low “profits” in time deposits.
Money gives me options, but is not necessarily an end goal. The
rational choice can be the one where we don’t end up with the “most”
money but with a better set of options.
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