Deciding whether to prioritize paying off a student or a car loan first can be a tricky decision.
Auto loans typically have shorter repayment periods, which means higher monthly payments. Conversely, student debt can be a particularly daunting due to the array of available repayment plans and forgiveness programs.
Unfortunately, there’s no easy answer to deciding which debt should be tackled first. Instead, borrowers should weigh a few critical factors to make the best decision for their financial situation.
Factor #1: Monthly Debt-to-Income Ratio
If a home purchase is in your future, considering how much debt you have in relation to your income is crucial. Even if you don’t plan to buy a home anytime soon, the impact of your monthly finances is still important.
Car loans usually have a shorter repayment period than student loans. While most student loans come with repayment plans of 10 years or more, auto loans normally span around five years. Because auto loans are repaid faster, a higher monthly payments are required. Therefore, if your goal is to maximize monthly cash flow, paying off your car loan could be the most effective strategy as it would free up more money each month.
If you’re a potential home buyer, this strategy could lead to qualifying for a larger mortgage. If you aren’t, paying off your car loan sooner can greatly increase your monthly disposable income.
[Further Readings: The Sherpa Guide to Buying a Home with Student Loans]
Factor #2: Interest Deductions
In your financial calculations, don’t overlook the student loan interest deduction.
As long as your income is not too high, you can deduct up to $2500 of student loan interest from your taxable income each year. While the savings might amount to no more than a few hundred dollars, this tax benefit could influence your decision in favor of prioritizing the loan that doesn’t offer such a deduction.
Factor #3: The Mental Standpoint
Human psychology plays a crucial role in managing debt, as our motivations significantly impact how effectively we save money and tackle our loans. If you’re particularly motivated to pay off a loan, you’re likely to save more diligently and make greater strides in reducing your debt.
For instance, if your student loans have been a source of major frustration or you’ve had negative experiences with your lender, using that frustration as motivation can help you pay off your loan faster. The sooner your loan is paid off, the sooner your lender stops profiting from you.
On the other hand, you may hate having a car payment. The idea that you are paying interest on a loan for an asset loses value every day may drive you nuts. Paying off your car loan can provide a sense of satisfaction every time you drive, knowing the car is fully yours.
Your specific motivators may differ. There are any number of reasons why you might prioritize paying off one debt over another. Maybe you’re eager to release a co-signer from their obligation, believe student loans are unlucky, or worry about your car breaking down. Whatever your reasoning, identifying a strong personal motivation to eliminate debt is a significant factor worth considering.
Factor #4: Refinancing Options
One potential wildcard in your analysis is the possibility that the interest rates on one or both of your loans could be reduced.
If there’s been an improvement in your income or credit score since you originally took out your loans, you might be well-positioned to secure a lower interest rate.
For example, suppose you owe $15,000 each on your car loan and your student loan. If your student loan has an 8% interest rate and your car loan has a 6% rate, it seems sensible at first glance to prioritize paying off the student loan first.
However, if you’re able to refinance your student loan with one of the refinancing companies offering rates around 5%, then it suddenly becomes more strategic to pay off the car loan first while securing a lower interest rate for your student loan.
Bottom Line: No Easy Answer Between Paying off Student Loans or a Car Loan First
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.
Next Steps:
- Consider other goals – Car loans and student debt are only part of the equation. Think about other priorities, like saving for retirement or buying a house.
- Know your repayment options – The variety of repayment options on federal student loans can create flexibility. Use the Department of Education’s Federal Repayment Simulator to explore different choices.
- Refinancing private debt opens doors – Borrowers can refinance to get lower interest rates or lower monthly payments. This page tracks the best student loan refinance rates currently available.
