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Posted February 27, 2009

Question:

Would it be a wise financial decision to pay off a vehicle loan of $3,000 with an interest rate of 4.99 percent with savings? Or should I keep my savings in the bank and continue to make minimal payments on the vehicle loan?

Answer:

According to FPA member Frank Nelson, CFP®, the simple answer to your question, given the information provided is: "Yes. You should pay off the $3,000 vehicle loan with an interest rate of 4.99 percent vs. leaving the money in the bank and making minimal payments on the vehicle loan."

The answer centers around what's called opportunity cost. It is the cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you can receivedby taking an alternative action. In this case, if you continue to make minimum loan payments it will cost you 4.99 percent on the unpaid balance. In this low interest rate economy, if you earn 2.00 percent on the money in your savings account, the opportunity cost for making the minimal loan payments is 2.99 percent (4.99 percent minus 2.00 percent). You would be better off paying the loan and avoiding paying this 2.99 percent difference. Also, keep in mind that unlike interest payments for your home mortgage and home equity loans, interest payments on vehicle loans are not income tax deductible.

However, there is one other thing to consider and that is your emergency fund. You should establish an emergency fund equal to three to six months of expenses. If the $3,000 represents the funds that you have set aside for an emergency fund, or if you have not established an emergency fund, then you might be better off establishing or maintaining the emergency fund and not paying off the vehicle loan until such time as you can do so and still have an appropriate emergency fund in place.

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