When it comes to knocking out debt, prioritization is a key to success. Paying a little extra on all of your loans is better than just paying the minimum, but it isn’t ideal. Often, the best way to attack debt is to pay the minimum on everything and savagely attack one loan. Once that debt is eliminated from your monthly budget, you move on to the next one until they are all gone.
Paying off a credit card first is normally the obvious choice because of the massive interest rates normally charged. After credit card debt is paid off, deciding between an auto loan and a student loan can be tricky. This is because these two loan types often have interest rates that are relatively close. When deciding what loan to pay off first, there are several important factors that should be considered.
Factor #1: Monthly Debt-to-Income Ratio
If a home purchase is in your future, this factor is critical. Even if you won’t be buying a home anytime soon, the size of your monthly payments still matter.
Often car loans have a shorter life than student loans. Most student loans come with repayment plans of 10 years or more while auto loans are normally around 5 years. Because auto loans need to be paid off faster, a higher monthly payment is required. If you are looking to get the most bang for your buck, paying off a car loan will often free up the most money each month.
If you are a home buyer, it means you can qualify for a better mortgage. If you aren’t, it still means that you free up a munch of money each month.
Factor #2: Interest Deductions
When you are doing your accounting math, one number that cannot be forgotten is the student loan interest deduction.
As long as your income is not too high, you can deduct up to $1500 of student loan interest from your taxes. Ultimately, the resulting savings maxes out at no more than a few hundred dollars, but if you are trying to decide which of two loans to pay off, this tax advantage could tip the scales.
Factor #3: The Mental Standpoint
Because we are not robots, human psychology is a factor that must be considered. You have to decide where your motivation lies. If you are highly motivated to pay off a loan, you will do a better job saving money and you will experience more success knocking out your debt.
Perhaps you are extremely frustrated by your student loans or you have had a terrible time with your lender. This frustration can be channeled into action. The sooner your loan is paid off, the sooner your lender stops making money off of you.
On the other hand, you may hate the idea of a car payment. The idea that you are paying interest on a loan for an asset that loses value with each day may drive you nuts. If you pay off your car loan, each time you get behind the wheel, you get the satisfaction of getting into your car.
These motivations may not work for you. There could be another reason you rush to pay off one debt over another. The possible reasons are endless. Perhaps you have a co-signer you want to get released. Maybe you think student loans are bad luck, or you fear your car is about to break down. Regardless of your reasoning, if you find strong motivation to pay off debt, it is a factor worth major consideration.
Factor #4: Refinancing Options
One potential wildcard in your analysis is that the interest rates on both your student loans and your car loan could drop. If your income or credit score has improved from the time you originally got your loans, you may have a good shot at locking in a lower rate.
Suppose you owe $15,000 on a car loan and $15,00 on a student loan. If the interest rate on the student loan is 8% while the interest on the car loan is 5%, it would seem that paying off the student loan first is the smart move.
However, if you refinance your student loan with one of the refinancing companies offering rates under 2%, the smart move is to pay of the car loan first, while you refinance your student debt at a lower rate.
Interest rates should be an important factor when you put together your debt repayment plans. However, they shouldn’t be the only factor. If you look at the big picture, you may find a route that makes you happier and saves you money in the long run.