Should You Pay Off Your Car Loan or Invest?

If you have come into some extra cash, you may be faced with one dilemma: pay off your car or invest? Both options have their benefits, but the decision largely depends on your financial goals, interest rates and risk tolerance, among other factors. Paying off your car loan can offer peace of mind and free up monthly cash flow, while investing may allow you to grow your money over time. There are advantages to each that are worth considering. 

A financial advisor can help you create a financial plan to prioritize your debt payments and save for short- and long-term goals. 

Benefits of Paying Off a Car Loan

Paying off your car loan early can offer several advantages. Here are four you to consider:

• Eliminating debt: Paying off your car loan will eliminate a monthly payment, freeing up your budget for other financial priorities. Without a car loan, you will have more flexibility to allocate your income toward savings, investments or other financial goals. For those who prefer a debt-free lifestyle, paying off the loan early can offer peace of mind.
• Saving on interest: Car loans can come with higher interest rates compared to other types of debt, especially if you have a subprime loan. Paying off your loan early reduces the amount of interest you will pay over time, potentially saving hundreds or even thousands of dollars. This can be particularly beneficial if your loan has a high interest rate.
• Improving cash flow: Without a car loan payment, you will have more cash available each month for other expenses or investments. This improved cash flow can give you greater financial flexibility and help you build an emergency fund, pay off other debts or start saving for large future purchases.
• Boosting financial security: Eliminating your car loan can also enhance your financial security. If you are hit with an unexpected expense or job loss, not having a car payment reduces your financial obligations, making it easier to weather financial hardships without risking your credit or falling behind on payments.

Benefits of Investing Extra Cash

Alternatively, if you prefer to invest your extra cash, it could help you build long-term wealth. Here are four common reasons to consider investing instead over paying off your car loan:

• Potential for higher returns: If the interest rate on your car loan is low–such as 3% or lower–investing your extra cash could yield higher returns over time. Historically, the stock market has averaged returns of around 7% to 10% annually, which can significantly outpace the interest paid on a car loan. This strategy can help you grow your money faster and build wealth over the long run.
• Compounding interest: When you invest, your returns can compound over time, meaning you earn interest on your interest. The earlier you invest, the more time your money has to grow, which can make a significant difference in the long term. By investing instead of paying off your car loan, you give your money the chance to work for you.
• Diversifying your financial goals: When investing, you are able to work toward multiple financial goals at once. Rather than focusing solely on debt elimination, you can begin building a retirement fund, contribute to an emergency fund or save for other long-term financial objectives.
• Taking advantage of tax-advantaged accounts: If you invest your extra cash into tax-advantaged accounts like a 401(k) or IRA, you can benefit from tax savings. Contributing to these accounts not only grows your investments but also reduces your taxable income, providing immediate financial benefits alongside long-term growth potential.

At a Glance: Paying Off Car vs. Investing

Other Considerations for Pay Off Car or Invest

When deciding between paying off your car loan or investing, there are four additional factors to consider:

• Interest rate on the car loan: Compare the interest rate on your car loan to the potential returns from investing. If your car loan has a high interest rate (for example, 6% or higher), it may make more sense to pay it off early. However, investing may provide better returns in the long run if your loan has a low interest rate.
• Impact on your credit score: Paying off a car loan can have mixed effects on your credit score. While eliminating debt is positive, it could reduce the diversity of your credit accounts and lower your overall credit utilization. On the other hand, continuing to make on-time payments can help build your credit over time, so consider the impact on your score when making a decision.
• Financial stability and risk tolerance: If you value financial security and want to reduce your debt obligations, paying off the car loan may be the safer choice. However, investing could be the better option if you are comfortable taking on some risk in exchange for the potential for higher returns. This is especially the case if you are planning for long-term goals like retirement.
• Emergency fund: Before you allocate extra cash to either paying off a loan or investing, make sure you have a sufficient emergency fund in place. Financial experts recommend saving at least three to six months' worth of living expenses to cover unexpected costs. If you do not have this safety net, it might be wise to prioritize building your emergency fund first.

Bottom Line

Whether you decide to pay off your car loan or invest your extra cash will depend on your financial situation, goals and risk tolerance. If eliminating debt and improving cash flow is your priority, paying off the car loan may be best. However, if you have a low-interest loan and want to pursue higher returns, investing could help grow your wealth. Consider your financial priorities, interest rates and long-term goals to decide which option is better for you.

Tips for Financial Planning

• A financial advisor can help you create a plan to manage your benefits. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
• One of the cornerstones of a good financial plan is having a good budget. SmartAsset's budget calculator can help you organize your finances based on the average budget of a person in your neighborhood.

Photo credit: ©iStock.com/milan2099, ©iStock.com/Delmaine Donson

The post Should You Pay Off Your Car Loan or Invest? appeared first on SmartReads by SmartAsset.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.