The internet is a dangerous place to ask for advice.
There are a lot of haters our there – trolls – who spew negativity because their life is miserable.
Yet everyone I’ve encountered on personal finance blogs is very accepting and the comment sections are full of positivity. There are people who offer help if you need help and it can be a weight off your shoulders knowing that you’re not alone with particular problems. My guess is anyone who takes the time to better themselves by reading stuff like this is just a little more awesome.
So I’m seeking your opinion on a not too hypothetical situation.
Imagine This…
These aren’t my numbers, but let’s go through this as a thought exercise. You have:
- $20k car loan, 5 years at 3%
- $50k student loan, 15 years at 6%
- $100k rental property mortgage, 25 years at 5%
After a fitful night of sleep, you wake up grumpy and blame it on your lumpy mattress. Why is it so lumpy? In an uncharacteristic fit of anger you punch the mattress. To your surprise, it feels like something is inside …
Not wanting a dead animal in there, you decide to cut it open with the best tool you have in your apartment: a kitchen knife.
The battle is long and messy, but eventually you make a hole big enough to peer in. It’s too dark to see anything and you are scared to just reach in. So you take out your iPhone, turn on the flash light, and finally get a glimpse.
$20k in cash is all yours.
What do you do with it?
Oh the Possibilities
Let’s quickly rule out blowing the money on an extended vacation. You want to use this to get ahead financially.
What a coincidence, your car loan balance is exactly $20k. Maybe you should just pay that off in full?
But the student loan is the highest interest rate – maybe the $20k should be put towards that?
You are also a rental property investor and that is exactly the down payment for another single family home. With a 20 year time horizon, you are confident you can make a 20% yearly return.
What is the right move?
People Face a Similar Decision all the Time
Many people with student loans are also contributing to retirement accounts. They are facing a similar decision with every paycheck – should I pay down my loan that is at 6% or contribute to my 401k with a tax advantaged projected 8% return?
If you run the math, it says to use low rate loans to your advantage. Rather than paying off a 3% car loan, you are better off putting that money to use anywhere else.
Obvious side note – that doesn’t mean it is a good idea to go get as expensive a car as possible to have a large loan. Let’s say the example above was actually two dependable $10k used cars, not one brand new car. You want a car that will get the job done and also to put your money to work.
Borrowing Money is Not Inherently Evil
Credit card debt is absolutely horrible. However, it is something that people can find help to get out of; the services of CreditAssociates are an example of the forms of debt relief that are available to people in such situations. About a third of Americans carry a balance and pay an extreme 20% interest on their borrowing. To make it worse, too often the money is used with very little thought to buy crap they don’t need. However, others are genuinely in need of money to help them out of a rut and that could require some flexible borrowing. A solution to this could be using a title loan (https://www.thenetlender.com) to help them acquire the necessary funds they need to get by – it involves utilizing the money tied up in your existing vehicle.
Credit card debt can seriously affect someone’s credit score and they may find that they can’t lend money when they need to as they have numerous debts against there name. There are specifically designed credit cards for no credit so if someone desperately needs a credit card, they do have a lifeline.
This hatred of credit card debt is extended to other areas as well. Rather than evaluating each situation on its merits, many are lazy and extend this belief too far, not realizing the power of leverage through rental property investing – loans your tenant pays off for you.
So I Have a Car Loan…
Car loans are in fact bad debt. You are paying for something that is worth less as time passes. Compare that to a rental property, where you are paying for an asset that keeps going up in value. Obviously one is better than the other.
Despite know this, I just purchased a used car and took out 100% financing! Shocking right? What was I thinking?
First, I am capable of purchasing without taking the financing into account. Too many people purchase the nicest car their monthly payment will allow.
I also know I have the discipline to pay it off early if it is the best path. In fact, I can treat it as a 4 month loan and pay it off completely in one lump sum. I decided to pay a little bit for this option with wedding and honeymoon expenses these next couple months.
But I’m interested in hearing your thoughts.
What Do You Think?
1) How should the person who found $20k in the mattress use the money?
2) Should someone who is purchasing a car and has a student loan at 6% – pay in cash OR take out a 3% car loan to pay down the student loan faster?
3) Should someone who has a student loan at 6% and is able to save $1k per month – pay down their student loan OR contribute to a 401k.
Paying off the car loan doesn’t make sense, since the interest rate is just 3%
Similarly the student loan which is tax deductible, is not worth paying off.
So, using this amount as downpayment for a good cash flow positive real estate makes sense, given the low interest rate environment.
I agree! So counter-intuitive though to keep around a loan on a depreciating asset.
I don’t see keeping a loan around on a depreciating asset as a bad thing. If that depreciating asset is a necessity (such as a car for transportation) it’s a different story.
It’s not like you are spending $3000 on an OLED television or a $1000 on a fancy purse. Even financing those at 3% is different than a car in my view. (Provided it is a reasonable car as you outlined.)
I actually have a car loan at around 3% (it might be 2.5%). I don’t mind it at all since I plan to keep it for 10-12 years. The loan will be paid of in 5 years (it’s a 60-month loan). The payments aren’t bad for 5 years and then I’ll get another 5-7 years of no payments.
I think in your scenario, I’d put more of the money toward the 401k and a little in the student loans. Depending on what my emergency fund reserves were, I might stash some money there instead of paying down student loans simply because there’s piece of mind with the flexibility of cash.
I know this is a real estate blog and I have a similar mindset with some properties myself, but I think people can stretch themselves too thin in trying to pick up properties and not have the funds for maintenance on them. I’m not sure that, given the other information, real estate investment is the best idea.
Glad to hear another financial blogger has a much maligned car loan. Mine is also 2.5% over 60 months. Pretty darn good rate if you ask me!
I agree I will have to be careful not to stretch myself too thin with properties. Right now things are going well, but there could be a turn ahead. There needs to be some built in cushion with the rental itself (rents far ahead of expenses) and my portfolio overall (cash reserves). I’m sure I’ll write more about that as I get closer to another investment!
From an economic point of view, the best solution is to attack the student debt which has a higher interest rate and no chance of financial gain–unlike investing in a new property.
Despite the fact that 20k is the downpayment on a rental property, that won’t cover closing fees, various taxes, expenses on upkeep etc., that will be needed.
But from a psychological pov, nothing beats the satisfaction of paying off a loan you’ve been dragging around for years. It boosts your self-esteem, gives you that rush of having achieved a goal (however small) and gives you renewed vigor to attack the bigger loans.
So from a strictly psychological point of view, pay off the $20k, pat yourself on the back and get back to the drawing board to figure out how to pay the student loan while saving for a property you can completely afford, all costs included.
You are right – the 20k would have to cover the closing costs as well. That would be possible with a property around $82k. Then the on-going costs would be covered by cash flow, but you would also need to hold on to some reserves, so would need to set some additional cash aside.
Glad to hear you are talking about the psychological aspect as well! I think that is a huge benefit of paying off a smaller debt first, even if it isn’t the highest interest rate.
Pay down that damn student loan.
The tenants pay the mortgage on the rental, and the car payment is so low its basically just keeping up with the inflation rate. Get rid off all student debt.
That would be nice! But is it better than another rental where the tenants pay the mortgage and the returns are 3x the 6% of the student debt?
Would you advocate someone pays down all their student loans before contributing to retirement accounts?
1) It totally depends on the person and how comfortable they are with risk. I’d be tempted to dump the 20k on my loans since that would knock them out by almost HALF. We are currently battling over a very similar situation in our own life– we’ve just recently received a 10k bonus. While 10k is a lot of money, its a drop in the bucket compared to our ~$600k of student loans. We have debated back and forth whether to put this toward a rental property or just put it towards loans. I think 90% of people would think we were NUTS for even considering purchasing a rental property with the amount of student loans we have. But looking over things long term, it makes cents, so it makes sense. The problem is we are simply uncomfortable with taking on more debt.
2) We had this exact situation and we took out the car loan to put more towards our student loans! It was an easy decision since the student loan we put it towards was almost at 8%.
3) I’d vote for putting that towards loans. 6% v. 8% isn’t a good enough reason to deviate in my opinion.
Yea everyones situation is going to be different. I wouldn’t suggest having many houses without a lot of equity in them or not having a strong cash reserve. But everyones risk, goals, time frame is different. I’d still go heavy on the loans, build cash, then buy the rental. I have 8 units now and 6 are paid for.
Thanks.
Yes, everyone has different options, goals, and risk tolerances. There are so many ways to get involved with real estate.
I feel equity isn’t a good cushion, cash reserves are much better. If you have a cash crunch, is equity going to make the bank happy? Not unless you sell in a panic.
Amber –
1) Yes, that makes the decision harder – what if you are nowhere near paying off the student loan? Does that change things? I would think so because it forces you to change the outlook from what is the best thing for the next 10 years to what is the best thing for the next 30? In fact the answer might be taking on some ‘good’ debt!
2) Smart move! Did you calculate how much that saved you in interest payments?