With the interest rate on my FNBO Direct Savings account falling like a rock (from 6% to 3.25% in six months) thanks to the Federal Reserve, I started thinking about other debt that I have. Fortunately, I'm a relatively debt free person. The wife and I have our mortgage, of course. We're not going to pay that off any time soon. I'm credit card and college debt free, so no worries there.
The one debt that I did have was my car. I was currently paying $366.57 each month to Capital One for my tidy, little 2006 Ford Focus. With 16 payments left, I was on schedule to pay another $5685.12 before I would officially own it. And so, I wondered, is it time for me to pay off the car?
Now, before I describe the process I went through to determine whether or not I should pay off my car loan, I want to point out that I agree with financial advisors that recommend that people should make sure they have a 3-6 month emergency fund before paying off large debts (credit card debts with huge interest rates possibly excluded). Even if I chose to pay off my car, I would still have a reasonable emergency fund, so I moved forward with my calculations.
To figure out whether or not paying off my car made a good idea, I did three calculations.
- Capital One Interest Saved - By paying off my car loan early, I would save a certain amount of interest that I would otherwise pay to Capital One. To figure out those savings, I went to BankRate.com and opened up their auto loan calculator. I plugged in the remaining loan amount ($5626.08), the number of months (16), and my interest rate (5.89%). The calculation returned that I would pay Capital One a total of $237.59 in interest.
- Savings Account Interest Lost - By taking the money out of my savings account to pay for the loan, that is interest that I will not be accruing over the next 16 months. To figure out the interest lost I went to the compound interest calculator on About.com, plugged in the remaining loan amount ($5626), the interest rate (2.7% - I'll explain this below), and the number of years (16 months = 1.33 years). This calculation showed that I would lose out on $202.92 in interest.
Why did I use 2.7% as my interest rate instead of the 3.25% that my bank posts? Because I have to pay taxes on that interest rate, which lowers my effective interest rate. Unlike mortgage interest, I cannot deduct my auto loan interest so I didn't change the interest rate in the first calculation. - Savings Account Interest Accrued - If I paid off my car, I would have $366.57 a month that would not be going to Capital One. I could take this money and spend it each month on fine wine and Nintendo Wii games, or, put it back into my savings account, thereby slowly replenishing what I took out to pay off the auto loan. Putting the money back into savings would also allow me to recapture some of the lost accrued interest. To determine the amount of interest that would accrue, I went to the savings calculator on calculatorweb.com. I plugged in the initial amount ($0), monthly savings ($366), the interest rate (2.7%), and the term of investment (1.33 years). This calculation told me that I would accrue $112.71 in interest during this time.
Taking these three numbers I could figure out what, if any, money I would save by paying off my car. I took calculation 1, added it to calculation 3, and subtracted calculation 2.
$237.59 + $112.71 - $202.92 = $147.38 saved!
That information gave me all I needed to know. I wrote out the check to Capital One, updated my weekly deduction to increase the amount going into my savings account, and paid off my car!
Here are the three links I used for my calculations, in case you want to check out your own savings:
- Bankrate.com - http://bankrate.com/brm/auto-loan-calculator.asp
- About.com - http://math.about.com/library/blcompoundinterest.htm
- Calculatorweb.com - http://www.calculatorweb.com/calculators/savingscalc.shtml
As always, let me know if you have any thoughts about my logic and/or calculations.
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