It’s tax season. Some will be getting significant tax refunds (and perhaps need to look at adjusting their withholdings). Others who have oversaved for taxes may have some extra cash on hand.
What should you do with that cash?
Answering that question is circumstantial and personal. Math plays a role (interest rates, potential annual returns). But it’s not the only thing that matters. Let’s look at one individual’s situation.
Should I Put Money Toward My Auto Loan or My Emergency Fund?
Should I pay down my auto loan or pad my emergency fund?
That’s what a Clark Howard listener recently asked.
Asked Goran in Georgia: “I’m getting a sizable tax return. I’m debating whether to put it towards my auto loan, which is at 6.7%, or into my emergency fund, which currently sits at one month’s worth of expenses (I’m adding more money weekly) and earning 4.85% interest.
“I’ve read it’s more valuable to build up the emergency fund, but I’m nervous about being upside down in my auto loan. Any advice is appreciated.”
Clark prefers a more gentle approach when encouraging people to build emergency funds. Start with a little money and slowly increase how much you’re putting aside, he says.
Eventually, he’d love for you to get to six months of expenses in that fund. If you’ve got next to nothing in that fund, which he sometimes calls a rainy day fund, it becomes a much bigger priority. Because then if an “oops” happens, chances are you’re turning to a high-interest credit card. And that’s no good.
In this case, Goran has one month of expenses in his emergency fund but he’s adding to it every week.
“I’m comfortable with you, since you’re already on a slow and steady buildup [with your emergency fund], using the tax refund to reduce the principal on that auto loan,” Clark says.
“But in order to know if that’s ultra efficient, you need to dig out your auto loan papers and you need to see if your interest is calculated on a formula known as a simple interest loan.”
Examining the Types of Auto Loans
As far as the auto loan, Goran mentioned he’s upside down. That means he owes more than the car is worth currently. That’s not a comfortable place to be.
Clark also surmises that Goran has a longer term on his auto loan than what Clark recommends. Or Goran bought his vehicle when auto prices were sky-high a few years ago.
With a simple interest loan, if you make an extra payment of $5,000, that will reduce the principal you owe by $5,000. And it means you’ll never have to pay another cent of interest on that $5,000.
However, the occasional auto loan issuer will do something Clark considers crooked.
“A key lesson for every person listening, watching: Whenever you’re taking out an auto loan, whenever, the only loan that is honest, decent, right, fair, is one that is a simple interest loan,” Clark says. “Any other lingo there, that lender, that dealer, is cheating you. They are ripping you off. And don’t let them do it. This is prevention. The best cure.”
Those auto loans that Clark detests are sometimes called “sum of digits” or “Rule of 78s.”
“It’s a method of cheating you on interest on a loan if you prepay it,” Clark says.
“If you’re in a cheater loan, all you’re doing is reducing the balance. You’re not having the impact you want. This is why reading the loan document is so important. In that case, you instead put the money in your savings account.”
Finally, if you need to change the fact that you’re upside down on the vehicle for whatever reason, you can always take the money you put into your emergency fund now and put it toward the vehicle loan at that time.
Final Thoughts
Should you put money toward your auto loan or emergency fund?
If your emergency fund doesn’t exist, start there. But if you’ve made at least some progress on an emergency fund, and your auto loan rate is more than you can get from a high-yield savings account, put the money there.
Just make sure your auto loan is a simple interest loan. Otherwise, you may not be better off paying down the loan.
