Paying off my Auto Loan

[Anonymous]

 Hi All, thanks for helping me on this. I'm considering paying off my auto loan in one lump sum to get rid of it. Will doing this help my credit, or perhaps hurt it?  Yes, I've eliminated my revolving credit first. 

For background- in 2006-  I leased a new car, and then eight months ago I decided to purchase the car before the lease was up through VW Credit. I financed the purchase with a $35,000 loan from VW at 3.9%.I currently owe $29,000 on the loan. While 3.9% is a great rate, I'm considering paying off the loan in full with my year-end bonus since I can't find a 3-year fixed income investment that pays near this rate (particularly after taxes). 

It seems that this should help my credit but I want to make sure. I noticed that MyFico doesn't provide a scenario for reducing installment credit, which made me suspicious.

Thanks for your help! 

[Anonymous]

Folks have reported their score moving both ways, although not usually by much.  I wouldn't pay off my car solely for a score boost.  If it's your only auto/installment loan that is where the drop would come in.  Though as you pointed out it could very well make financial sense.  If you have access to 3-6 months worth of expenses for an emergency, I'd pay it off, score be darned.  Wow, what a great feeling that must be.  I'm jealous

[Anonymous]

Hi dempsy,

Thanks for your post.

You're in a great position financially.

But this is a no-brainer. My advice is to stay liquid.

Even though you can't find an investment that returns 3.9%,

the peace of mind of having $29,000 in cold hard cash with your

name on it in the midst of "The Great Recession" is infinitely

more valuable to you right now than any return you could achieve.

Cash is King, and it gives you options. If you pay off the car, the 

options disappear. It's called keeping your powder dry --- there will

be other investments, but you need cash to take advantage of them.

Plus, if you pay off your car now you will "win" once and "lose" twice:

-- You'll have complete ownership of the car with a clear title (win)

-- You'll no longer have $29,000 in cash on hand (loss)

-- Your car will continue to depreciate in value (loss)

Paying off something you own in a lump sum that depreciates in value

isn't the highest and best use of your money now. However, paying off

your car over time on a monthly basis will preserve your cash and improve

your credit gradually.

You were smart to pay off your revolving debt first (fluctuating payments)

because it's far more risky than installment debt (fixed monthly payments). 

The FICO software is calibrated so that paying off risky credit card debt

rewards you with more points faster than paying off an installment loan.

And for FICO High Achievers, the goal is to get your installment loans

paid down to about 30% or less of the original amount owed to maximize

scores. You can do some searches here in the forum regarding FICO High

Achievers for more details.

So to recap, you're in an AWESOME place right now. Continue to pay your bills

on time and maximize your cash position so you can take advantage of

investments down the road. I think you know in your heart that you can

do much better than 3.9%, but it requires some patience for the time being.

Keep up the great work, dempsy!!!! 

CanDo

"The right attitude is everything" 

[Anonymous]

Hi again dempsy, 

One last thing I'd like to pass along to you regarding your car:

I bought a new car last summer ( 2009 Hyundai Sonata GLS )

and the General Manager of the dealership --- who just happened

to also be the Used Car Sales Manager --- gave me a very valuable

tip regarding how to stay ahead of depreciation. Here it is:

The first year you own your car, make your monthly payments like

you normally would. But also make additional principal payments that

total at least $2,500. You can pay it all at once or spread it over the

course of the year. It doesn't matter.

Then, every subsequent year you own the car, make your monthly payments

plus at least an additional $1,500 per year in principal only payments. 

In a simpler form, it looks like this:

Year 1 - regular payments plus $2,500

Every year thereafter - regular payments plus $1,500

You can always pay more principal if you like, but this is the

basic formula he shared with me. 

Most people keep their cars for about 3 years before trading them in.

So if you follow this formula, you should come out ahead when it comes

to buying a new one. 

As I'm sure you know, depreciation varies from model to model. But this is a

general rule of thumb from someone who's in the business of buying cars every day.

So it might make more economic sense for you to simply stay ahead of depreciation

and hang on to your lump sum of cash, as opposed to paying off the car and owning

something that loses value every day.

It's something to think about,  dempsy. Please let us know what you decide to do.

Enjoy your day!!!

CanDo

"The right attitude is everything" 

[Anonymous]

Thanks for the great feedback and advice from both of you. You make a compelling case "CanDo" and I appreciate your perspective. There is a lot to be said for having cash, as you point out. It would be a shame to give up 3.9% financing since that rate is very hard to get now. 

The other perspective would be this: I would still have some cash left to put in the bank after buying out my car and my cash flow would improve by roughly $800 per month, so I would still have a bit of a cushion and would reduce my monthly expense burden significantly.  The other factor is my goal to have a down payment for a house in the next three years which means that any cash I invest over that time horizon would have to be low risk. In order for me to beat the effective 4% after-tax return I would receive by paying off my loan, I would need to find an investment or portfolio with a 3 year duration that payed at least 6% before taxes. To get to 6% in this market  over that horizon requires taking some risk and to get a meaningful return of 8% would require  significant risk with a mix of equities and junk bonds, which seems to be too much risk for a mere extra 2%. The other way to look at it would be that if I put the cash in the bank at the current money market rates, the luxury of having some extra cash to fall back on would cost me roughly $2,000 over the next three years, or roughly 7% of principle. 

Everything is a trade off, I guess. I'll think about it.

Thanks for the alternative perspective.

[Anonymous]

Thanks. I admit I haven't given much thought to the aspect of depreciation. I wonder how much depreciation matters at this point since I'm on the hook for the car either way. I mean once I decided to borrow the money to buy it, I assumed the liability of depreciation then and there. That isn't going to change if I pay for the car over the next four years or if I pre-pay it in lump sum, right? Or am I missing something? 

[Anonymous]

Hey dempsy,

You're right. You did assume the liability of depreciation

when you bought the car. But your choice of words is

exactly correct. When it comes to owning a car, depreciation

is a liability...not an asset.

Now if you owned rental property, then writing off depreciation

is definitely an asset because you can use it to offset income.

But when you own a car, it's a different matter entirely.

If you know for sure that you're going to keep the car over the

next 4 years, then pre-paying or paying monthly doesn't matter.

However, if you'd like to keep your car options open and beat the

depreciation at the same time, then paying monthly and paying

a bit extra in principal makes more sense. You'll stay ahead of depreciation

and keep your cash. And once you have 9 payments or less left on your

car loan, it won't be counted against you in your debt to income

calculation when you're ready to buy a house. 

Now you make a good point: paying off your car will increase your

monthly cashflow by $800/month and you'll own the car free and clear.

But that also means it's going to take you somewhere between 2.5 to 3

years to rebuild the $29,000 in cash that you have in your pocket right now.

And I know you can appreciate the time value of money --- money today is

worth more than money tomorrow. 

Since a house is definitely in your future, I'd say that growing your cash

should be a primary concern. It won't grow if you pay off your car lump sum,

but you won't lose money if you leave it parked in cash, a money market, CD, etc. 

So like I said, right now it's all about cash. If you have it, along with great

credit, you can pretty much write your own ticket. From what you've posted

so far, that sounds just like you.

Either way, you'll end up owning the car. But given the current state

of our economy, it's best to keep your options open. Having said that,

whatever you decide will be the right decision. After all, it's your money... 

Just something to think about, dempsy.

Thanks so much for getting back to me. Enjoy your evening!!!

Edit to Add: I'm not exactly sure how you'll "lose" $2,000 a year

over the next 3 years by keeping the 29k in cash. If you're talking

about inflation, there isn't any. We're in a deflationary period right now.

Anything you buy now will be worth less tomorrow than it is today. That's

part of the reason so many businesses are either going out of business

or struggling to stay in business. They can't sell to make a profit --- they

sell to break even (if they're lucky).

Even if you parked the money in a 1yr CD yielding 2.5-3% and rolled it over

each year, you will still come out way ahead. Like I said, there's no inflation

to eat away at your buying power. The profits are taxable, but the net return

will still be more than $29,000 2-3 years from now....

CanDo

"The right attitude is everything" 

Message Edited by CanDoAttitude on 01-02-2009 04:50 PM

[Anonymous]

Thanks for all of the feedback. To be clear, it's $29,100 if I pay for it in lump sum today but it's $31,800 in total payments if I finance it over the next 3 years due to the 3.9% rate on the loan. Paying for it early saves me $2,800 in financing costs. I came up with the "$2,000 cost " by subtracting the $2,800 I would pay in interest from the $800 I would earn in the MM account over that period on the $30K.  It really comes down to what you said earlier about the value of cash in hand: do I want to pay $2K in net financing costs to have access to $30K in cash in the bank over the next 3 years or would I rather give up the $30,000 but save myself $2K in net financing costs in the process. 

Perhaps in the context of FICO, the thing to do is pay the auto loan down by $20K, keep the other $10K in the bank for a rainy day. This way, I get the auto loan balance below 30% of its original amount and I continue to make payments for another year which might boost my FICO. I also eliminate the bulk of the financing costs. 

It's a judgment call.  Thanks again! 

[Anonymous]

Now you're cookin', dempsy!!!!

I think that paying 20k towards the car and keeping 10k

in the bank is an excellent choice. Your FICO scores will rise,

you'll stay liquid and there's cash on hand in case something

unforseen happens. Also, rebuilding your cash to approx 30k

over the next 2-3 years is a lot easier when you have 10k to start with.

Additionally, if you crunch the numbers I think you'll find that by

paying 20k towards the car your final net interest rate will be less

than 3.9%. Your lender won't make any money on the 20k, but they

won't lose money...and that's the name of the game during a recession.

Like I said, dempsy, anything you decide is the right decision because

it's your money. And not everyone would take time to seek advice from

people they don't know (especially online), so I appreciate the opportunity

to let us chime in. You're WAYYYYY ahead of the curve anyway...

Thanks again. Enjoy the weekend!!!

CanDo

"The right attitude is everything" 

[Anonymous]

i don't know cando, i think i might pay it off.

no one knows what will happen tomorrow and getting out from under a car payment may be the best decision.

however, it must be kept in mind that i believe paying $29,000 for a car, which is never anything but a liability, is crazy.  most people don't feel that way and probably look at money completely different than i do

after all, i paid $9,000 for my car and paid it off 3 years early  oh, and i still think i paid too much