I have $26,000 in an online savings account with a 1.99% interest rate. My only debt is my car loan, I have about $3,000 left at an interest rate of 4%. I'm considering purchasing a home this year to take advantage of the first-time home buyer credit. My parents will match whatever I am able to save for a down payment. Since the interest rate on my savings account is lower than my loan, should I pay off the loan? I currently save at least $300 per month, sometimes more ($2500 since the beginning of the year) and would put the entire $230 monthly car payment into savings.
As is the case with many personal finance questions, the answer is "it depends". Generally speaking, paying down debt is a good idea. Right now, you are earning just under 2 percent on your cash and the car loan is costing you double that. So, it would appear that eliminating the debt would be a good idea.
However, there are a couple of things to consider here. First, how much will your new home cost? If you are looking at something in the $250,000 range, a downpayment of up to $50,000 may be required to qualify for the best possible mortgage rates. Even counting the generous match from your parents, you don't have quite enough money to cover the downpayment and the closing costs that will come along with the mortgage. Also, you wouldn't want to spend everything you have just getting into the home. Once you move in, you will be buying a lot of new things for the house (tools, lawnmowers, furniture, etc) and having an adequate emergency is just as important as ever.
I personally like the flexibility that comes with having extra cash available so I wouldn't rush to pay off the car loan just yet. My answer might be different if your overall debt ratio was preventing you from qualifying for a mortgage. The general guidelines used by most responsible lenders is that the principal, interest, taxes and insurance (PITI) payment that you make each month should not exceed 28 percent of your gross monthly income. In addition, the PITI payment plus all your outstanding long term debt (your car payment would count here) should not exceed 36 percent of your monthly income. If you are failing the 36 percent debt ratio, paying off the car loan might be required. That doesn't appear to be a concern in your particular situation, but it is a factor that might come into play for other people who want to buy a home and wonder if eliminating debt is something they should consider.
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