How should we split our funds between a savings account, brokerage account, and car loan?
We are both 24 years old, have dual income, no kids, and are curious about the best way to split our funds between our savings account, brokerage account, and car loan. Right now we have $2,600 a month set aside for savings ($2k) and debt ($600). We put $900 into a brokerage account (mutual funds right now), and $1100 into a savings account. We owe $25k for a car loan ($570 per month at 2.74% for 4 years), and want to pay this down within the next 2-3 years, or less. I get a 10-15% ($8-9k) bonus each year and will put at least $2k into the loan payments from that each year. We have about $30k liquid money saved, $45k equity into our current house, and about $15k in retirement accounts.
Would it be a smart idea to take some money out of the $1100 that goes into savings and pay down the debt sooner, because rate is 2.74% and our bank account interest isn't close to that? If so, how much of that savings should we put towards our debt?
Paying off your car will save some, but most car loans have fairly low interest rates these days, averaging 2.98% for a 60-month new car note.
But the majority of car loans are calculated using what’s called the simple interest method. This means the interest paid each month is based on the loan’s outstanding balance. The earlier you pay off or pay down these loans, the more you will save in interest payments. You can figure out how much you could save on your particular loan by plugging your numbers into a calculator like the one at Bankrate.com.
It may not seem significant but the reason for getting out of a loan like this early is that you will be freeing up money in your budget every month. There is an opportunity cost involved whenever you borrow money, and it is a cost many people do not consider.
This is the same logic that suggests it is a good idea to get out of your mortgage (even with a low rate) before you retire. It is not the hefty interest rates associated with these debts, but rather the fact that you have them that stops you from doing other things.
The average monthly payment on a car loan right now is $471, what else could you do with that money each month? If you invest it instead at a 6% interest rate, you would have close to $77,000 after 10 years.
If you do decide to put your bonus money toward your auto loan, you want to make sure you are actually paying down principal. In many cases, paying extra will signal to the lender not that you are trying to reduce the amount of interest paid or get out of the loan early, but that you do not have to make another payment for a few months. If you want the payment to go toward principal you should call the lender and ask how to make that happen.
It doesn't make sense to buy a car with such a high loan balance. It means you are living above your means. In the future, consider buying a used car in cash which will make much more sense; usually a car about 4 years old has most of the depreciation already passed. You are also probably too heavily invested in your house, so that even a 20% drop in housing prices could put you underwater. You probably won't want to sell your house, but that is the most prudent course of action. One way or another, you should be concentrating on building up your liquid savings rather than spending so much on a house and a car and perhaps other expenses which are not necessary. The fact that your car loan far exceeds your total retirement account balance is evidence that you are in a dangerous situation.
At 2.74% you're getting a really good rate for a car loan, however, the principle is fairly large. I wouldn't compare your bank account interest rate to the car loan, rather the car loan to what you're earning with your investments. The savings account should be viewed as your emergency fund and/or any other near-term financial obligations. If you have roughly 3-6 months of living expenses saved in the savings account for unexpected expenses, you could consider using a partial amount of the $1100 towards long-term investments. Your investments over the long-term will likely grow more than 2.74% on average each year given you've invested as a 24-year-old should, rather aggressively. However, you can't really go wrong with paying down your car loan either and using the $1100 towards paying it off quicker isn't a bad idea. This is a classic case of opportunity cost. What could you money be doing instead of paying off that loan? It'd be a no-brainer if the interest rate was much higher, but because it's so low you should at least consider using part of the excess after your emergency fund is established towards long-term investments in either retirement accounts, or a taxable brokerage account.
That’s a hefty car payment, so it’s a good idea to get that out of the way and free yourself up to invest more. Don’t go crazy and pay it all off tomorrow, but the money you’re saving is getting undermined if you have interest building on a $25,000 loan.
You mention $600 going toward debt - does that refer to the car loan, or do you have another balance you’re paying off? If there are no other credit cards or student loans with worse rates, pay the car off aggressively. If you care about your finances above all, you might want to consider trading the vehicle in for something cheaper. If that’s not in the cards, push most of that $1,100 toward the car. The faster you’re done with those payments, the more you’ll be able to grow your overall wealth.
It sounds like you’re earning good money and have your sights set on the future. Get that debt out of the way and then get to work building your retirement and investment accounts.
You could pay down the car loan sooner, however with a low interest rate you sound disciplined enough to save the money diligently and can put the savings to work better in another investment vehicle that would provide a higher return. You should have 3-6 months of expenses in liquid savings and your $30k may very well be sufficient. I would also suggest (if eligible based on income) maxing out your Roth IRA's by contributing $5500 per year and diversifying into several low expense mutual funds. Contributions to a Roth IRA can be withdrawn anytime without tax or penalty so this provides an additional cushion if need be, but should really be a last resort since this money is earmarked for retirement. You didn't mention your housing status as this could also be a source for funding a new home. Depending on your shorter term goals, putting money into IRAs and tax deferred retirement savings can provide you with better leverage in growing your assets long-term. If however you'll need your savings in a few years, it's important to match your investment risk to your time horizon and you would be wise to save in a brokerage account or bank outside of your retirement.