Should Your Pay Off Student Loans or Buy a Car?
If you’ve come into a large sum of money, whether it come from an inheritance or a bonus at work, it’s easy to feel that money burning a hole in your pocket. Buying a new car can be tempting, or you might want to pay off your student loans.
Compare the benefits of either financial move to see which one is the better choice for you.
The Case for Buy a New Car
There are a few arguments you can make in favor of buying a new car.
Your old car is breaking down
The clearest reason to buy a new car is that your old car is breaking down. Your car is supposed to be a reliable way of getting you from point A to point B when you need it to. If your car is constantly broken or breaking down when you need it most, it’s natural to want a new car. New cars are far more reliable than old cars, so purchasing a new one will solve this issue.
You need a car for work or family reasons
Many people need a car for work or family-related reasons. Picture being a pizza delivery person without a car for example. Whether you need the ability to drive to offsite locations for work or need a way to bring your children to soccer practice, lots of people need a car for work or family reasons. If you don’t already have a car or have to chare a car with someone else, buying a new one can make life much easier.
Student loans assistance or forgiveness
Some employers offer to pay a portion of their employee’s student loans as a benefit or will fund continuing education for their employees. You also might be eligible for student loan forgiveness if you are in a qualifying line of work.
If you’re lucky enough to find yourself in such a situation, it might make sense to only make minimum payments on your loans, allowing your employer or a loan forgiveness program to handle the rest.
You really want a new car
Possibly the weakest, but most psychologically appealing argument is that you really want the car. Fancy cars are powerful status symbols and many people find themselves drawn to the bells and whistles that come with new vehicles. If you’ve come into extra cash, it’s easy to think you deserve a nice new car.
New monthly payment added
When arguing in favor of buying a new car, remember that new cars cost a lot of money. If you don’t buy the car outright, you’ll have to make your car loan payment each month. This new monthly payment can stretch your budget, reducing your ability to spend on entertainment and luxuries.
The Case for Paying Off Student Loans
Paying off student loans is the more prudent financial decision, for a few reasons.
Guaranteed interest savings
When you pay off a debt ahead of schedule, you are securing a guaranteed rate of return. Picture the following scenario:
You have $50,000 in student loan debt that you’ll pay off over ten years. The interest rate on the student debt is 5%. Over the course of ten years, you’ll make 120 $530 payments, for a total of $63,639 paid. If you come into $50,000 and use it to pay off your loan in one fell swoop, you’ll immediately save $13,639 in interest costs.
If you instead used the money to buy a car, you’d be stuck paying the $13,639 in interest, and only have a depreciating asset to show for it.
Don’t discount the psychological benefits of paying off student loans and being debt free. It’s well-known that people who pay off their debts are generally happier and feel much less stress.
Being burdened with debt can impact your confidence, relationships, and ability to plan for the future.
Paying off your student debt can be very freeing and give you the chance to get a fresh start financially.
Lower debt-to-income ratio
If you want to apply for a large loan, such as a mortgage in the near future, paying off your student loans can be a big help.
Other than your credit score, one of the main things that lenders look at when deciding to approve or deny a loan is your debt-to-income ratio.
The debt-to-income ratio is calculated by dividing your total debts by your annual income.
It serves as a measure of how able you are to take on a new monthly bill.
Using your windfall to pay off your student debt will reduce this ratio. That improves your chances of qualifying for loans in the future.
More cash flow each month
Every loan you have requires a monthly payment, and there’s usually a minimum amount you must pay. By paying off your student debts, you’re removing a required payment that you have to make each month. That frees up some of your monthly income for other purposes. Whether you decide to save that newly freed-up cash flow or to spend it on fun, having more money available is never a bad thing.
Student loans in bankruptcy
Declaring bankruptcy is like pressing the reset button on your financial life. It can help you escape debts that you have no chance of paying and get a new start. One of the downsides of student loans is that they cannot be discharged in bankruptcy without meeting incredibly specific requirements.
If you’re experiencing financial trouble and come into some extra cash, the best thing to do is to focus on paying off student debt because bankruptcy won’t get rid of the debts.
Your employer provides transportation
If you don’t truly need a car, there’s less reason or you to buy one. Some employers will provide transportation when you need it, letting you borrow the company car for site visits. Some employers also offer benefits such as discounted public transit passes. If your employer offers these benefits, use them instead of buying a car you don’t need.
What’s the Smart Move?
In nearly all situations, paying off student loans is the right choice to make.
The only time you should buy a new car is if you don’t have one and you absolutely need one to be able to earn an income or improve your financial prospects. If you are in that situation, you should buy the cheapest reliable car that you can. Opting for a used car instead of a new car is a great way to save money while still getting the vehicle that you need.
If you already have a car, you should stick with it as long as you can while you’re paying off your debts.
Build an Emergency Fund Before Doing Either
It’s important to remember that you should prioritize building an emergency fund over either a new car or extra loan payments. If you come into extra money and don’t have an emergency fund, start building one.
Emergency funds are incredibly important because they can help you avoid costly debt.
Consider this example:
You don’t have an emergency fund. You get hurt and have to visit the hospital and incur a $2,000 bill. Because you don’t have an emergency fund, you have two choices: use a credit card or don’t pay the bill.
Not paying the bill will ruin your credit and cause debt collectors to chase you down, so you decide to pay the bill with a credit card. Your card charges 20% interest and you make the $50 minimum payment each month. It will take you five and a half years to pay off your bill, costing you almost $3,300 in monthly payments.
If you instead had an emergency fund, you could have paid the $2,000 out of pocket, avoiding years of debt and more than $1,000 in interest costs.
Emergency funds can be handy for all sorts of situations, like medical bills, unexpected expenses, or job losses. A good rule of thumb is to keep between 3 to 6 months’ expenses in your emergency fund. That will be enough to help you handle even large emergencies.
You should keep your emergency fund in an online savings account. They pay better interest rates than other savings accounts and make it slightly harder to access the money. That reduces the temptation to spend the money on non-emergencies.
Consolidate or Refinance Student Loans
If you're not going to pay off your student loans, it is worth thinking about consolidating or refinancing your student loans. By consolidating the debt, you can reduce the amount of interest that you pay. Or, by refinancing, you may be able to lower the monthly payments, which can help with your car purchase if you're going to use an auto loan.
Though buying a new car with a windfall can be very tempting, it’s usually a better idea to use the money to pay off student loans. Just keep in mind that you should build an emergency fund before you do anything else.