Should I Pay Off My Car Loan or Invest?

Assumptions

• Both paths spend the same amount each month and are measured on the same date.
• The loan rate, expected return and marginal tax rate are constant throughout.
• Returns arrive smoothly. Volatility, sequence risk and fund fees are not modelled.
• Car loan interest is treated as non-deductible, which is correct for personal use.
• Taxable gains are taxed annually at your marginal rate, harsher than real long-term capital-gains treatment.
• Tax-deferred balances are taxed in full at withdrawal; the up-front deduction is not modelled.
• Extra payments reduce principal in the month they are made and shorten the term.
• The car’s value, depreciation, insurance and running costs are excluded — they are identical on both paths.
• No prepayment penalty applies. Most US car loans are simple-interest and have none, but some are not.

Sources

• CFPB — Auto loans
• IRS Publication 550 — Investment Income and Expenses
• IRS Topic No. 409 — Capital Gains and Losses
• Federal Reserve — Consumer Credit (G.19) release

Common questions

Should I pay off my car loan early or invest the money?

Pay it off if the loan rate beats what you would earn after tax, and invest otherwise. In a taxable account the bar is your loan rate divided by one minus your tax rate, a 7.2% loan in a 22% bracket needs a 9.23% return to beat, which is above most long-run expectations. In a Roth or 401(k) the bar is just the loan rate itself.

Why is the bar higher than my loan rate?

Only in a taxable account, and only because the two returns are taxed differently. Not paying interest is not income, so nothing is taken from it; investment gains are income, so something is. A guaranteed untaxed 7.2% is worth more than a taxed 7.2%, and the gap is exactly the tax.

Does it matter that the car is depreciating?

Not for this comparison. The car loses value at the same rate whichever way you pay for it, so it cancels out of the difference between the two paths. It matters enormously for a different question, whether you are underwater, and overpaying closes that gap sooner, which is a real benefit this expected-value model does not price.

What if my car loan is at 0% or 2%?

Then investing almost certainly wins, and the calculator will say so. A subsidised or promotional rate sets a very low bar, and there is little reason to retire cheap debt early when the same money can compound. Note that a 0% offer is usually taken instead of a cash rebate, so its true cost is the rebate you gave up.

Should I pay off the car or a credit card first?

The credit card, almost always, its rate is typically three times the car loan’s, and the same logic applies with a much higher bar. If you hold several balances, the order you clear them in is worth working out first.

What about my employer’s retirement match?

Take it before either. A 50% match is a 50% guaranteed return on the day you contribute, which no car loan rate comes close to. The match against paying off debt works that out; this calculator assumes the match is already handled.

How does this differ from a mortgage payoff decision?

Two ways. Car loan interest is never deductible, so there is no tax relief lowering the bar as there can be on a mortgage. And the horizon is years rather than decades, which leaves far less room for a market return to average out.