Should I save my money or send extra money toward a loan?

About a year ago, I bought a new car. Not being too far out of college, my credit wasn't well established and I was forced to finance with what I'd call an affordable, but slightly higher-than-average interest rate.

Since buying my car, my fiance and I eliminated our credit card debt, bought a house, and started saving regularly. But after a few months of putting my money into retirement accounts that weren't really earning anything given the 2008 market conditions, I began to second-guess my decisions to save.

"Should I be putting money into a retirement account that is earning almost nothing? Or should I be sending that extra $$$ to my auto lender?"

I set out to find the answer. I considered the tax benefits of putting money into a 401(k), an IRA, or a Roth IRA. I took into account my current tax bracket, my future tax bracket, the current interest rate of my loan, and the expected rate of return on my retirement account (average rate during the term that my car loan is still active).

I assumed that I was going to pay at least the regular car payment for the next 3.8 years, and would have a few hundred bucks to put away, either in the tax-advantaged retirement account or toward my high-interest car loan (at about 8%). I wanted to see how much money I would have at the end of the 3.8 years that my car loan expires.

Keep in mind, I can either pay nothing extra toward my car and put my extra money in my retirement account. But if I send the money to the auto lender and pay off the loan early, I will be able to put both my extra money and the regular car payment into the retirement account for the amount of time that I would have been paying off until the loan was originally set to expire. Let's say that my loan matures in four years, my normal payment is $500/month, and I have $250 to play with each month. If I send that $250 to the lender every month and pay off my loan in three years instead of four, for that last year, I can put both the $500 and the $250 into my retirement account.

So assuming that once the loan is paid off I will put my money into the retirement account, I calculated what the value of the retirement account would be at the time of the loan's scheduled maturity for both the accelerated loan payoff and the normal loan payoff.

I created a spreadsheet to help make an objective decision regarding loans vs savings. All yellow cells are variables. Do you have any outstanding loans or credit card debt? Do you save money each month? If the interest you're earning on your savings is low enough and the interest you're paying on loans is high enough, maybe you should pay it off early. But maybe not!

Use my spreadsheet calculator to help find out.

Also, the second sheet of the spreadsheet tells you whether you should put your money into a traditional IRA or a Roth IRA, based on how much money you have to save. Turns out, the more money you're able to save each month, the more sense it makes to put it into a Roth IRA. The less money you have, the more sense it makes to put it in a Traditional IRA. This is because you may contribute up to $5,000 per year (2008) to either, and since the Roth is after-tax money, you can really contribute more (because after-tax money is worth more than pre-tax money).

Post a comment with any questions.