Save and Invest

Should you build your emergency savings or pay off your car loan?

Twenty/20

If you've recently come into some extra money, perhaps from a raise or bonus, you might wonder the best way to maximize your surplus funds. Saving is an obvious choice, especially for those who don't have a few months' worth of living expenses stashed away.

But you might also consider tackling a big regular expense, like your auto loan. Car owners currently owe $1.18 trillion on their auto loans, according to a 2019 study from Experian, averaging $32,187 for new and $20,137 for used cars. Making extra payments toward a car loan could go a long way to helping you become debt free.

While it's always smart to aggressively pay off high-interest obligations, like credit card debt, as soon as possible so you pay less in interest over time, paying off other forms of debt shouldn't necessarily take precedence over padding an emergency fund, Christian Patterson, wealth advisor at Exencial Wealth Advisors, tells CNBC Make It.

If you're debating between paying off your car or increasing your savings, here's what to keep in mind.

The case for saving before paying off debt

If you don't have much in the way of savings, research from economists Emily Gallagher and Jorge Sabat suggests aiming for roughly $2,500 to get you started. That's enough to feel relatively stable, the researchers found, and cover many emergencies that might arise so you don't have to rely on credit. Keep it in a high-yield savings account with an online bank, which typically offer better interest rates than brick and mortars.

Then you can focus on paying off any debt with an interest rate above "5-ish%," writes Rachel Sanborn, director of advisory services at Ellevest, an online investment platform.

Once the high-interest debt is paid off, put any surplus funds toward additional padding for your emergency fund. Experts say three to six months' worth of take-home pay is the ideal, but save as much as makes you comfortable.

If you're a freelancer or small business owner, for example, you might prefer to have six months to a year's worth of monthly expenses stashed away. If you have a relatively stable job and earnings, you might be okay with a bit less. Once you make that calculation, you can tackle any remaining lower-interest debt, of which your auto loan is likely a part.

The interest rate on your car loan depends on a host of factors, including your credit score. But the average rate for a new car loan is around 5.7%, according to Edmunds. That puts it on the edge of Sanborn's 5-ish% rule. Still, 5.7% is low enough that you can likely feel okay about saving any surplus money over paying down your loan sooner. Plus, continuous on-time bill payments each month can boost your credit score (not that adding a few points to your score should be your sole consideration, especially if paying your debt down quicker could save a lot of money on interest).

"Building an emergency savings fund is an important personal finance pillar," Amy Thomann, head of consumer credit education at TransUnion, tells CNBC Make It. "If you feel as though you have a good repayment schedule in place for your auto loan, you may decide to put the cash into a savings account. This can help limit the need to use debt to finance an unexpected, large expense in the future."

If you have a solid emergency fund, and you're deciding between paying off your car loan or investing for retirement, Patterson, of Exencial Wealth Advisors, says that the math likely favors investing, assuming your auto loan rate is relatively low. Historically, the stock market has returned around 10% on average, though experts expect that to decrease in the future.

"The difference in the percentage rate on your loan and the return from your investments would be the 'opportunity cost,'" says Patterson. "If your car loan is at 1.9% APR, but you could earn a 6% return by investing your extra money, you would be missing out on a potential 4.1% excess return."

The case for paying off debt before saving

One reason to prioritize paying off debt before boosting your emergency savings is for the mental relief, Suze Orman, personal finance expert and best-selling author of "Women & Money," previously told CNBC Make It.

"Debt is bondage," she says. "You will never, ever, ever have financial freedom if you have debt."

Being in debt often causes negative psychological effects, adds Patterson, which can be reversed by making extra payments to pay down the balance. Plus, once the debt is paid off, you can redirect your monthly payments to other goals, like saving or investing.

"Seeing debt numbers rapidly decrease allows a person to feel freer from their debt, and ultimately feel a sense of accomplishment once they achieve the goal they're working toward," Patterson says.

It's similar to the debate between the snowball versus avalanche methods of debt repayment. While it's technically financially more prudent to use the avalanche method and pay off the debt with the highest interest rate first — because this will save you the most money on interest payments in the long term — research shows that people have more success with the snowball method of paying off the debt with the lowest balance first. Paying off one debt completely and quickly, and then moving to the next, builds momentum.

Individuals need to do what makes them feel the most secure and confident in their own financial lives.

"At the end of the day, any money you're putting toward debt or investing is a step in the right direction," writes Ellevest's Sanborn.

Don't miss: You may be paying off your credit card debt wrong—here's the best way

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