Deciding whether to pay off a student or car loan first can be a tricky question.
Auto loans usually have shorter repayment periods, which means higher monthly payments. Student debt can be a minefield of confusion with the variety of repayment plans and forgiveness programs.
Sadly, there isn’t an easy answer to deciding which debt should be paid off first. Instead, borrowers need to consider a few critical factors.
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 five years. Because auto loans are repaid 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.
For a home buyer, it means qualifying for a bigger mortgage. If you aren’t, it still means that you free up a bunch of money each month.
[Further Readings: The Sherpa Guide to Buying a Home with Student Loans]
Factor #2: Interest Deductions
When you are doing your accounting math, one crucial number 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 tops 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 for consideration. 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 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 a strong motivation to pay off debt, it is a factor worth considering.
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 $15,000 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 around 2%, the smart move is to pay off the car loan first while refinancing your student debt at a lower rate.
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 refinance rates currently available.