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Debt Management Plan vs. Auto Loan

Is it smarter to pay-off my auto loan or contribute money to my debt management plan.

I am selling my car and I am debating what to put the money towards. I am selling my car for $7,000. Should I pay off my existing car loan? I owe $10,000, my monthly payment is ~$370/mo, interest rate 8%, I've never missed a payment, and the account is in good standing. OR....should I put the money towards my debt management account. I've had this account for a little over a year. It includes 4 credit cards that are all way over due and effecting my credit rating. Payment is $487/mo. Not sure what to do.

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Highlights

  • Pay your highest-interest debts first.
  • Most vehicle loans are upside-down.
  • Monthly fees boost the cost of a debt management plan.

I hear this question often. The rule of thumb is to pay down your highest-interest account first, and your question gives me the chance to prove the rule. The challenge in answering your question is I do not know the balance enrolled in your debt management plan (DMP) or the interest rate. Accordingly, I will guess at these two important terms to test the accuracy of the rule.

Vehicle Loan Interest Expense

First, let us look at the vehicle loan. You mentioned the key terms are a $10,000 loan balance and a 8% interest rate. Your monthly payment is $370, and the vehicle's current market value is $7,000. My guess is that based on the balance, payment, and interest rate, you have about 30 months remaining on the loan. Below find an abbreviated amortization schedule of this debt:

Month Payment Principal Interest Cumulative Interest Balance Remaining
Feb. 2011 $368.88 $302.22 $66.67 $66.67 $9,697.78
Mar. 2011 $368.88 $304.23 $64.65 $131.32 $9,393.55
April 2011 $368.88 $306.26 $62.62 $193.94 $9,087.29
24 months not included here
May 2013 $368.88 $361.60 $7.28 $1,059.18 $730.45
June 2013 $368.88 $364.01 $4.87 $1,064.05 $366.44
July 2013 $368.88 $366.44 $2.44 $1,066.50 $0.00

From this point forward, if my assumptions and calculations are correct, you will pay a total of $1,066.50 in interest expense if you continue to make the monthly payments.

Now let us look at a complete table if you apply the $7,000 proceeds from the sale to the vehicle loan:

Month Payment Principal Interest Cumulative Interest Balance Remaining
Feb. 2011 $7,368.88 $7,302.22 $66.67 $66.67 $2,697.78
Mar. 2011 $368.88 $350.90 $17.99 $84.65 $2,346.89
April 2011 $368.88 $353.24 $15.65 $100.30 $1,993.65
May 2011 $368.88 $355.59 $13.29 $113.59 $1,638.06
June 2011 $368.88 $357.96 $10.92 $124.51 $1,280.09
July 2011 $368.88 $360.35 $8.53 $133.04 $919.74
Aug. 2011 $368.88 $362.75 $6.13 $139.17 $556.99
Sept. 2011 $368.88 $365.17 $3.71 $142.89 $191.82
Oct. 2011 $193.10 $191.82 $1.28 $144.17 $0.00

As you can see, applying a one-time payment of $7,000 to the remaining $10,000 balance slashes the length of the loan and the amount of interest expense. You would have nine months remaining, during which you would pay $144 in interest.

Debt Management Plan Interest Expense

As mentioned at the beginning of my answer, I must make several assumptions about the amount enrolled in the DMP and the interest rate the provider charges you. My analysis is also incomplete because I do not know the amount in monthly fees you pay.

For purposes of discussion, I will assume you have $21,750 enrolled in the DMP, are paying 12% in interest, and have a five-year term. The later two figures are industry averages, and I used them and your monthly payment to back into the balance owed. Let us look at the numbers in our amortization schedule:

Month Payment Principal Interest Cumulative Interest Balance Remaining
Feb. 2011 $483.82 $266.32 $217.50 $217.50 $21,483.68
Mar. 2011 $483.82 $268.98 $214.84 $432.34 $21,214.70
April 2011 $483.82 $271.67 $212.15 $644.48 $20,943.03
54 months not included here
Nov. 2015 $483.82 $469.59 $14.23 $7,264.68 $953.31
Dec. 2015 $483.82 $474.28 $9.53 $7,274.21 $479.03
Jan. 2016 $483.82 $479.03 $4.79 $7,279.00 $0.00

The amount of interest paid at the end of the five-year DMP will be about $7,300.

Now let us look at the schedule if we apply a $7,000 payment at the beginning of the term:

Month Payment Principal Interest Cumulative Interest Balance Remaining
Feb. 2011 $7,483.82 $7,266.32 $217.50 $217.50 $14,483.68
Mar. 2011 $483.82 $338.98 $144.84 $362.34 $14,144.70
April 2011 $483.82 $342.37 $141.45 $503.78 $13,802.33
31 months not included here
Dec. 2013 $483.82 $470.74 $13.08 $3,020.72 $837.13
Jan. 2014 $483.82 $475.45 $8.37 $3,029.09 $361.69
Feb. 2014 $365.30 $361.69 $3.62 $3,032.71 $0.00

Doing so knocks off 23 months from the plan and cuts the DMP interest expense to about $3,000. Again, this assumes zero DMP fees, which is not accurate.

Analysis: Debt Management Plan vs. Auto Loan

Applying the $7,000 to the auto loan reduces the interest expense from about $1,000 to about $150. Applying the $7,000 to the DMP reduces the interest expense from about $7,300 to about $3,000 — a $4,300 savings! If you include the monthly DMP fees, the 23-month time reduction makes applying the $7,000 to the DMP an even smarter move.

However, even though it is a smart move to apply the sale price of the auto to your DMP, you will almost certainly not be able to do so. Why? The vehicle is the security for its loan. In all jurisdictions I am aware of, the vehicle title will include the name of the creditor on the title. You will need to get approval from the creditor to sell the vehicle. A condition of selling a vehicle used as security is to pay the entire loan balance. For you to sell the vehicle you must pay the creditor the proceeds of the sale plus whatever remains on the loan.

In other words, selling the vehicle is a great idea if you do not need it. But to do so, you will need to pay the creditor $3,000 to retire the loan, which will mean that instead of walking away from the sale with the full $7,000 in your pocket, you will have to pay $3,000. Selling the car will reduce your monthly cash-flow bleed by $370, but it will cost you $3,000 to do so.

I hope that the information I have provided helps you Find. Learn. Save.

Best,

Bill

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