Retirement plan decisions made easy
Drill Down: Contribute to a 401k or Pay Off the Car Loan?
Should you pay off that car loan before starting contributions to your 401k plan? To answer that, let’s begin with a simpler question. Suppose you lend your brother $100 at eight percent interest and borrow $100 from your sister at eight percent interest. When the two loans are paid off, will you be better or worse off than when you started? Obviously, you’ll be in exactly the same position. To be better off, you need to charge your brother a higher interest rate than you pay your sister. So the simple starting point for the car loan question is whether the total return on your 401k will be higher or lower than the interest rate you’re paying on your car loan.
Over the last few years, banks have been charging between six and eight percent interest on car loans. (We don’t count financing arranged by dealers, because they often grant lower interest rates in exchange for a higher price on the car.) The investment returns on your 401k are not so simple to calculate, unless your employer offers to match your contribution. If the employer matches even a little of your contribution, then your 401k will earn far more than the interest you pay on your car loan.
If there is no match from your employer, a rough long run average for a moderately conservative investment portfolio is roughly eight percent a year. Car loans, on average, cost a little less than what you can earn in your 401k. In other words, you’re better off leaving the car loan in place and contributing to your 401k.
However, the difference in interest between the two choices is small enough that other factors can be considered. For instance, if you have a very strong urge to be debt-free and if you are definitely going to stay out of debt after the car is paid off, then it’s not such a bad idea. However, most people will find it easier to discipline their spending if they contribute to the 401k rather than making extra payments on their car.
The decision is up to you, but in most cases, you’ll be better off contributing to your 401k rather than paying off your car loan early.
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
» Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
The 401k ebook is available in text, audio, and video formats. The current selected format is audio. You may also switch to the text or video formats by clicking on the icons at the top of the main lesson page.