I will explain my entire thought process behind the decision to refinance my cars. I will start by telling you the reasons why I refinanced and everything that was going on in my mind while I was talking to the credit union for an hour.

### Background

I bought both the cars (a Mercedes and a Ford) in 2013. I financed both of them with the manufacturer’s preferred financial institutions because both of them gave me an incentive via a discount on the purchase price.

I had very limited credit history (just one credit card and nothing else, that too was just about 2 years old). The rates that I received were upwards of 9% for one car and upwards of 6% on the other.

Soon afterwards, I refinanced both the car loans with my local credit union. With the exact same credit history (limited), I was able to get an interest rate of 3.89%. They dropped it a quarter point further (0.25% or 25 basis points) because I agreed to take a credit card (this was my second credit card ever).

I made all the payments on time for these 2.5 years. As expected my credit score improved tremendously.

### Why did I decide to refinance today

- Interest rate of 3.64% was too high. I knew I will get the best rate (or very close) available given my very good credit history now.
- I wanted cash out of my ‘equity in the car’ –
*more on that later in this post* - I do not foresee any large purchase on credit coming up soon (like a mortgage), so a little temporary drop in the credit score (by an additional inquiry today) does not bother me.

### Here is how the process went

I was on the phone with the credit union. I explained to them my situation and inquired about my refinancing options. The lady on the other side (we will call her Fiona) explained to me the options. She tried to tell me what my monthly payment will be if I refinance it for 24 months.

I was like – why would I want to refinance for 24 months? She was correct in her logic, my original loan term was 5 years, a little over 2.5 years have passed, so she was guessing I will refinance to be in line with ‘getting done with my loans by the 5 year mark’.

I explained to her that I would prefer the loan term again to be 60 months. She told me I will end up paying more interest. I told her I am good with that.

While we were filling the application, I happened to ask her ‘What is the longest term the credit union?’, she said ’75 months’. I immediately said “Oh, then I would like to refinance for 75 months”.

She asked me some details about the cars (most notable was the mileage) that I gladly provided. Given the make, model, year, mileage, packages installed; she came up with a ‘current market value’ of the car. The first car was valued at $26,400 and the second car was valued at 20,xxx (I was too busy running my Excel spreadsheet with other loan related calculations to note down the exact number).

She asked me how much money do I want to get out of my ‘equity in the car’, I said ‘maximum possible’. She said they usually do 80% LTV (Loan To Value). They can go up to 100% but then they suggest that I sign up for gap insurance. She explained to me what gap insurance is and also gave a personal example from her life. I politely declined the gap insurance.

Both my loan applications were instantly approved and she came back with two options – 75 months @2.94% or 60 months @1.94%. Oh, now suddenly I had a choice to make. This is where I struggled the most today, almost everything else was a no brainer.

### I decided to go with 60 months @1.94%

- At 1.94%, I feel confident that I will be able to earn a better return on my investments. At 2.94%, I am still confident but not as much – I am not sure if I will invest all the ‘cash out’ in equities, perhaps a mix of equities and fixed income securities (bonds). My personal bonds favorite ETF is BIV. The yield for the last 12 months has been 2.66%.
- There is a strong likelihood that I will not even have these cars for 75 more months. I intend to use them for as long as possible provided I am not hassled by the maintenance and repairs. The cars will be about 9 years old in 75 months, my guess is maintenance problems would trigger an upgrade sooner.

Fiona told me my credit score was 753, I did not inquire about which credit bureau was she referring to. Just to give you an idea about the credit score and FICO score, I knew my FICO score 778.

Oh and one more thing – Although the Mercedes was valued at $26,400; their credit underwriter only approved me of $26,000. I could have requested Fiona to go back to the credit underwriter to change that but I did a quick calculation in my mind – an extra $400 invested per year will give me 8% pre-tax, 6% post-tax, and let’s say I pay credit union 2%, I will have 4% remaining with me. That means $400 * 4% = $16 per year. I did not feel like bothering Fiona for that much money.

And probably I lost an opportunity to a few dollars on the Ford deal too but I can live with that.

The entire process took about an hour, partly because Fiona and I had a couple of friendly conversations in between.

### Here is the difference

** At 10am:** I was paying $836 per month (together for Mercedes and the Ford)

**I was paying $812 per month and had $22,810 cash in my hand (**

*At 11am:**figuratively*– actually I will have the money tomorrow morning)

In case you are thinking my interest rate fell from 3.64% to 1.94% but my monthly payments only fell from $836 to $812. Well, you have to understand that earlier I was paying interest on a certain amount of outstanding balance, now I am paying interest on that certain amount + this additional $22,810.

If you are thinking the other way round – what an awesome deal, I got $22,810 in cash in return of only a $24 increase in monthly payment. Wait – earlier my loan payments would have ended in 2018 but now they will go on till 2020.

**Notes**

- Fiona was also kind enough to overnight the cashier’s check to me that I will receive tomorrow morning (the credit union paid $35 for doing me this favor)
- She also mentioned that a credit score of 730+ is considered A+ by them, so the interest rates would remain unchanged as long as you have more than 730 (mine was 753)

**One last tip –** if you are trying to take cash out of equity (be it car or any other asset), then the most respectable reason is ‘home improvement’ – a tip that Fiona gave me, probably because she is always friendly or probably because I was very respectful to her, we will never know 🙂

I wrote this entire post because I wanted you (the reader) to know how I think. I wanted you to know how I think so that you can also start thinking like me, thinking like a Pro. And I assure you that you will, if you keep reading my posts.

**Disclaimer:** Taking cash out of an asset like car or a house is risky, specially if you are not 100% financially responsible. I can very well imagine a case where someone takes out cash out of a car and spends on a vacation -> ending up in more debt rather than building wealth.

Leave a comment with any questions, or suggestions, or agreements, or disagreements. Any discussion is good discussion.

Hi Bobby,

1) Enjoying your blog tremendously. Read practically every post. I have very similar views as you and also enjoy fairly high income/salary, so face some of the same questions/issues/decisions.

2) A big thank you for taking the time to ‘document’ your experiences and reasoning

3) Question:

So, I did the same today on a smaller scale. I also refinanced my car loan. I am getting some $10K cash back.

Question: Should I invest it, or should I reduce the principle on my mortgage? I did not see any posts around mortgages.

The problem is: I am not positive I can get a much better rate of return by investing. I wish I could get the ‘average 8%’. This year and last my 401K is practically flat.

The car loan is a ‘simple interest’, whereas the mortgage on the house is ‘with accumulation’.

Original mortgage terms: Borrowed $145K in Oct 2012. 30 years conventional fixed @ 3.5%.

Monthly payment: $651.11

Original mortgage maturity: Oct 2042

Original amount of interest to pay for the life of the loan: $89,401.33

Current principal: 126,800 (I made some extra payments already)

Current maturity date: Jan 2040

Current total interest: ~ 77K

If I apply these $10K towards the principle now

Maturity date: Mar 2037

Total interest: ~ 65K

Paying off $10K now would end the loan in Mar 2037 (would shave 33 months) and would reduce the amount of interest by about $12K for the span of the ~ 21 years left to pay it off.

Thanks in advance for any insight

—

Craig

Hey Craig,

1 – High income issues are good issues to have

2 – You are most welcome. It is my pleasure to be able to share what I know

3 – If I were you, I would not pay down the mortgage. Here is why:

I do not know your exact income so do not know your tax bracket or how much mortgage interest you can deduct (it phases out at higher income levels). But let us say that you are in the 33% tax bracket and are able to deduct 3.5% mortgage interest that you pay. So IRS is giving you 33% of 3.5% back = 1.2%. (By paying 3.5% in mortgage interest, you are paying 1.2% less in taxes). So essentially the effective tax rate is only 3.5% – 1.2% = 2.3%.

I strongly believe that any even S&P 500 will return much more than 2.3% over a long period of time. So why pay down debt that is costing you less than what your investments can make?

I am not surprised that your 401k has been flat the last couple of years. A well balanced portfolio has not returned anything in this time frame. US stocks have returned little while international stocks and commodities both have fallen.And you are right – there is no blog post on mortgage yet. Would you like to write one together with me? It will bring a fresh style of thinking and writing to my blog. You write a rough draft and send to me. I will review for accuracy and add my 2 cents and we can publish it under your name 🙂

Hi Bobby,

Hi Bobby,

On the subject of paying back the morgage quicker: I guess the difference is the time horizon. Even though the S&P did not perform in the last couple of years, we expect it will over a 20 year period. Let’s hope so.

I can give it a try to write an article about mortgages, but not real sure about the exact subject. Can you clarify? Maybe a direct e-mail would be better?

Hey Craig,

Your logic is correct about the time horizon but that does not apply to your situation. You have a long time horizon, so you need to evaluate your ‘returns’ over that long time horizon.

Let us say S&P 500 returns 10% (per year average) over the next 10 years. For every $100 you invest in S&P 500 today will become $260. So your gains are $160. You would have paid an interest of only $25 (2.3% per year for 10 years on $100). So you are $160 – $25 = $135 better off.

If your time horizon was 1 years, then the whole equation changes, because S&P 500 might lose 40% value in a year, while the 2.3% ‘cost of funds’ remain the same. So you would lose money in the stock market as well as pay additional interest that could have been avoided by paying down the principal.

Please look out for a direct email from me about the article on mortgages.

Cheers