Pay Down Auto Loan at 1.9% or Invest?

There are several solid reasons for both paying down your debt and investing your money in the market. Which would you choose?

For many investors, it’s difficult to decide whether to pay down low-interest debt or use available cash to invest. On one hand, people highly value being debt free. But on the other hand, people can do basic math. Borrowing money at 1.9% and expecting to receive an 8% return seems pretty attractive.

There really is no right answer to this question. One of the great things about personal finance is that it’s personal to you. I put together the following pro/con list because the question comes up so often. Let me know which camp you belong to in the comments below.

The case for paying off debt

  1. Flip the Question. Would you borrow cash at 1.9% to invest with the hope of earning more than what it costs to service your debt? When you’re examining the question, there’s no difference between these two scenarios. Many people will choose to invest when deciding between paying down low-interest debt or investing but would never borrow from a bank to invest on margin. If you’re not a fan of investing on margin, you should make sure you’re looking at this question through the right lens.
  2. Being Debt Free Feels Good. When I paid off my student loans, for the first time in decades I found myself completely 100% debt free. And you know what? It felt magical (and still does). I don’t owe anything to anybody. I’m sure that will change if I take on a mortgage in the future, but living debt free is addictive. I recognize that people have different feelings about this, but I encourage you to give yourself the feeling of being debt free and see if you like it. Once you’ve escaped the chains of your student loans and other consumer debt, I think you’ll be less likely to want to return to debt.
  3. Frees Up Cash Flow. If you have debt, you must make enough money to service it. This restricts your cash flow and keeps you from being able to do other stuff with your cash. If you’re investing the money, your investments could temporarily tank (i.e. 2008-2010). The auto loan doesn’t care that the money you invested is worth half as much as it was when you thought about paying cash for the car. You still need to make the monthly payment. If you want to change jobs, you’ll need to factor in the monthly payments on your debt as well. By signing up for the debt, you’ve committed to keeping your income at a certain level (base spending + debt servicing). If you change your mind, you’ll either have to sell your investment at a loss or incur capital gains. Neither option may be optimal.
  4. Where Do You Draw the Line? If you believe that investing is the way to go to take advantage of the spread, where do you draw the line? Should you finance your next iPhone purchase at 0% interest so you can invest the difference? How about a trip to Home Depot? A decade ago it was popular among personal finance bloggers to talk of a strategy borrowing from credit cards at 0% interest and parking the money in a high-yield savings account earning 5% interest. Since you could expect to get about 18 months interest-free, for every $10,000 you could arbitrage, you stood to make about $750, less taxes. This always struck me as a lot of work for a pretty small payday. If you’re using debt arbitrage to bulk up your investments, one should calculate your actual rate of return. Often the spread barely justifies the hassle of keeping up with the forms and accounts. It seems like a lot of mental energy for a small return. You’d probably be better served focusing on increasing your income.
  5. Complexity vs Simplicity. Warren Buffett said “There seems to be some perverse human characteristic that likes to make easy things difficult.” By getting caught up in the question, you’re undoubtedly making something simple more difficult. Most of our lives only get more complicated as time goes on (i.e. marriage, kids, health, mortgage) and there’s something to be said about simplifying your financial life. For one thing, I hope this blog is showing that your financial life doesn’t need to be complicated. If you’d rather focus your life energy on something else, paying off the debt is an easy choice. Once the debt is paid off, it disappears from your life completely.

The case for investing

  1. Math. It’s pretty obvious, but if you can borrow money at a lower rate than you receive on an investment, you will make money. If we assume a 1.9% loan and a 8% investment return, the difference is a mere $610 on a $10,000 loan. But if you run the scenario for 50 years, if you invest $10,000 at 8% per year you’ll have $469,016 in 50 years. Meanwhile, your measly auto loan will only be $25,627, this letting you pocket the difference of $443,389. That’s not exactly chump change (of course, don’t forget that in 50 years $400K won’t be worth nearly what it’s worth today thanks to the ravages of inflation).
  2. Limited Access to Retirement Accounts. The most compelling reason to invest rather than pay down the debt is if you otherwise wouldn’t be able to max out your retirement accounts. Annual retirement space is “use or it lose it”, so if you neglect to contribute to your 401(k) this year while you’re busy paying down a 1.9% loan, there’s no opportunity to catch up next year. If I was in this situation, I’d almost certainly do whatever it takes to max out retirement savings before I paid down a low interest debt (including student loans). The benefits of retirement accounts and the tax arbitrage are just too great.
  3. Set Up Autopay. Carrying the debt isn’t that complicated. Sure, it’s one more account to keep track of and of course you need to be careful that you don’t make a mistake that causes the interest rate to jump up. But that’s easily handled by setting up automatic payments. Set it once and then forget it.
  4. Forced Savings. By keeping the loan and requiring yourself to make monthly payments to service it, you’ve effectively forced yourself to save. For example, if you have $10,000 set aside for a car but decide to take out a loan instead and to throw your $10,000 into Vanguard, you’ve basically committed yourself to saving $10,000 by making the loans payments. There’s something to be said for putting your back up against a wall and requiring your future self to save. If you pay for the car in cash, there’s no certainty that you’ll spend the next few years saving the equivalent of a car payment each month. By opening yourself to the opportunity of reallocating the money to something else, you’re setting up the possibility of failure.
  5. How About a 0% Loan? Sure, you might not go to a bank to borrow 1.9% with the hope of making a great return in the stock market. But would you do it if they offered a 0% loan? What if someone said they’d give you a $1 million loan at 0% interest for 5 years. Would you take it? I would. $1 million in a 5-year CD earns 2.0%, so that’d be a cool $20,000 a year for almost no risk. If you’re reluctant to borrow at 0%, what about -1%? If this is convincing to you, we’re no longer talking about whether you’d invest on margin, we’re negotiating on the price. So while 3-4% might seem unattractive, when rates start to get closer to 0% it might feel like a better deal.

Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Empower keeping track of his money. He’s also maxing out tax-advantaged accounts like 529 Plans to minimize his taxable income.

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    Eighteen thoughts on Pay Down Auto Loan at 1.9% or Invest?

    1. Love #1 – don’t think anyone would borrow just to invest…but it seem’s justified to not pay off lower interest loans. It is STILL debt – money you owe. In my experience, most folks don’t actually invest the difference and /or increase their lifestyle since they have the low-cost debt. Which keeps them in debt …

      1. That’s my experience as well. People say they’ll invest the difference but then lifestyle creep takes place. It doesn’t have to be a big jump either, but with the extra cash sloshing around in the system it’s easy to increase consumption without even realizing it. If you do, you’re tricking yourself into thinking you’re “investing the difference”.

    2. Last year, I bought a car and took an $8k loan out at 5%. 3 months later I paid it off. For me, it was a matter of freeing up cash flow and the “addictive-ness” of being debt free. I have a mortgage, but I also have roommates (I don’t have to worry too much about that debt for now.)

      The feeling of being debt free is amazing. Going forward, I will most likely take out loans if I start a business or look to buy rental properties or commercial real estate. If you want to build an empire, levering up via credit is a great way, however, make sure you can pay the bank back 🙂

    3. My last student loan that I had was at 2.75% and I asked myself the same question. For a while I paid the minimum and invested the difference. But when the balance got below $4k, I was like “is this even worth it?” I was basically letting $4k get in the way of me being totally debt free. So one day last September, I believe, just paid it off. It wasn’t worth the emotional hassle to me of having debt.

      1. I feel the same. It’s a lot of hassle to arbitrage such a small amount. Easier to pay it off and free up energy for other things. In my experience most people that get to a position of being debt free strongly resist getting back into debt, unless it is for a leveraged asset like real estate.

    4. I’m generally in the camp of investing because of the math. But like Miss Bonnie MD said…do most people invest rather than pay off debt or do they just spend it? Most of those who enjoy reading about personal finance are probably more disciplined with their money. While that’s true, I’ve been moving a little bit to the pay down loan camp even with low interest rates. Too often I have money earning very little in a “high yield” savings account because I’m thinking about buying another rental property or maybe a primary residence and the money just sits there.

    5. I agree with most of the logic here, but your general “8% investment return” undermines your argument. If you’re extremely lucky, you can get 8%. This reminds me of the nearly insolvent pension programs across the country, who based their future solubility on similar wishful thinking. Your 8% also doesn’t account for capital gains or fees, so unless you’re investing in a tax-deferred way (i.e. retirement), the actual gains need to be greater than 8% to actually get an 8% return.

      1. The uncertainty of investment returns definitely undermines the argument for investing. If you can’t get 8% in the market, then what are we really talking about here vs a fixed 1.9% payment? Making a few extra pennies!

    6. I’m walking down the middle of the road on this one. I currently have a zero percent car loan in its last year so I could reinvest the cash rather then pay the down payment. On the flip side from time to time I put money on the mortgage if my tax advantaged accounts are maxed. The answer is highly personal after all. In my case I only relate debts to my risk free rate. So mortgage equals bond and the associate allocation beyond emergency fund.

    7. I think have a written down plan is important as it helps you stick through bad times and not get too crazy during the good times. Overall, as long as you’re in it for the long term that’s the key to investing success.

    8. Nice summary of the key considerations for this very common question. I’d finance at 0%, because that truly is free money, but not for any positive interest rate. I’d also be sure that once the 0% interest rate ended, I’d pay in full.

    9. I don’t know anyone who is truly debt free. Most of us who live on the Coasts (where most of the big money jobs are) have jumbo mortgages because that’s the only way to buy a house in a great school district. So debt free is a myth.

      Certainly it makes sense to zero out consumer debt if you can. But better to max out 401k & 529 plans than to pay cash for a car when 1.9% money is available. Because the 401k comes with an immediate 40% return (deferred tax anyway).

    10. I would love an easy calculator where I could put in assumptions. I am considering an expensive purchase that offers a 1.9% interest rate for 5 years .. it would seem to me unless there is a crash in the market that should get more than 2% year return by investing and borrowing..

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