There seems to be an instinct, as soon as we get some extra money, to pay off the loan on the car. If this is you, don’t do it! It’s an understandable instinct – that payment shows up in the bills every month, and it would be nice to get it off the books so that your budget can drop. But here are the problems with this:

Firstly, your car loan is unlikely to be your highest interest-rate debt, and ideally you want to pay off the highest interest one first. More about this in a bit.

But secondly, I’m sorry to say that the monthly payment for a car is usually an ongoing expense. Once you get this car paid off, then presumably in 5 years, or 10 years, or 20 years’ time you will be buying another. And so when you pay off this one, it’s smart to keep some amount in the budget, and put it into savings every month to start preparing for the next car. In a two-car household, for example, if you drive your cars for 10 years before replacing them, then that means that every 10 years you will be buying two cars – an average of one car every five years. So whether you are paying off the current one or saving for the next one, that dollar amount is a pretty constant monthly expense.

So in that sense, I don’t even really think of a car loan as “debt”. Yes, of course it’s a debt, but it’s in a very different category from something like credit card- or student loan debt. Those are numbers that you truly want to get out of your budget, and once they are paid off then that expense is gone, hopefully never to return.

So if you get some extra money, use it to pay off your highest interest rate credit card debt first. If you have no credit card debt, congratulations! – use it then to pay off student loan debt, unless you have a special payment plan. And if you have no debt at all, then make sure that your emergency savings is in good shape before you consider putting some of it towards the car.

From a numerical standpoint, these make a lot more sense. The average car loan interest rate in 2020 was 5.3% for a 5 year loan [1], while credit card interest rates typically range from about 10% to 30%. So paying down your credit cards first is going to save you a lot more money on interest. And once you get your credit card debt reduced, your credit score will improve, giving you a lower interest rate on your next car loan! (Note: if you have a higher interest rate on your car loan, then see how it stacks up against your credit cards, and pay towards the highest interest rate one first.)

Keep the car loan. Sure, if you have all your debt paid off and your savings are in great shape and you get some extra money, then pay off that loan. But keep some amount in your monthly budget to save for the next one, because sure enough, that expense will find its way back.

If you need any help figuring out your priorities for spending, saving and paying off debt, give me a call. And if you know anyone who might be wondering about the same thing, please do share this.

Note 1: https://www.valuepenguin.com/auto-loans/average-auto-loan-interest-rates

The photograph is of a plethora of stop signs on a corner on the UC Davis campus.  The sign on the left has since been removed.