When you have extra money in your budget, you might want to make extra payments on your loans so you can pay them off sooner.
When it comes to student loans and an auto loan, you might get stumped on which to focus on first.
Choosing either one would help improve your finances as you reduce your debt, but which one could treat your wallet better?
The Money-Conscious Approach
In an ideal situation, you have a stable source of income and healthy finances.
If you already have an emergency fund, some retirement savings, and aren’t having trouble paying the bills, you’re in a great position to make extra payments on your loans.
In this situation, you should aim to try to save the most money by paying your loans off early.
Simply put, you should focus on paying off the loan that charges the highest interest rate.
A loan’s interest rate can be thought of as the price of the loan. You pay interest for the privilege of borrowing the money. The higher the interest rate, the more expensive the loan is.
The lower the interest rate, the less expensive it is. Higher rates also translate to higher monthly payments. If you have two loans with the same term and for the same amount, the one with the higher rate will cost more each month.
Paying down a high-interest loan means that less interest will accrue on the loan over time.
Sending all of your extra money to your higher rate loan will result in the greatest savings.
Consider this example:
You have $15,000 in a student loan with an interest rate of 7% APR. You also have an $8,000 car loan charging 3.75% APR. The student loan has 4 years of its term remaining while the car loan has 2 years left.
Your minimum payment for the student loan will be $359.19 each month. For the car loan, the minimum will be $346.51. Combined, you have to pay a total of $705.70 each month.
If you make just the minimum payments on each loan, you’ll pay $2,241.30 on your student loan and $316.24 on your car loan.
If you have enough money to pay $1,000 towards your loans each month, you can save a lot of money.
If you target your student loans first, then, once those are paid off, put the full amount towards your car loan, you’ll pay off all your loans much sooner.
Instead of taking four years, you’ll be debt-free in just over two years. Additionally, you’ll pay just over $1,450 in interest, instead of more than $2,500.
If you focus on your car loan first, you’ll pay the loan off faster, but pay more interest overall. The total interest cost on your loans will be $1,590, almost $150 more than if you’d prioritized payments on the student loan.
Reasons To Pay Down An Auto Loan
Paying down the higher interest loan is the optimal strategy mathematically, but life is rarely that simple.
There are a number of arguments as to why you should focus on your car loan before your student loan.
One reason that you should focus on your car loan first is if you are in a less stable place financially and your car is essential to your source of income.
For example, if you are a pizza delivery driver, what would you do to earn money without a car? If you work in the next town over and there’s no public transit available, could you get to work without a car?
Paying off your car loan means that you truly own your vehicle. You don’t have to worry about losing your car if you are unable to make the loan payments.
When your vehicle is absolutely essential to your ability to making an income, this is important.
If you experience a financial emergency and can’t pay your car bill because of it, then lose your job because you can’t get to work because your car was taken away, one financial problem will have snowballed into a seemingly insurmountable situation.
Owning your car outright can avoid that and give you a way to get back on your feet.
Access to student loan deferment or forbearance
Another reason you might focus on paying off a car loan over a student loan is if your student loans are in deferment or forbearance.
There are a number of situations in which you are not required to make payments on your student loans. Most of them are related to financial hardship.
Pros & Cons of Deferment
In this situation, you should focus on making car loan payments so you can keep your vehicle and use it to get to work.
The issue with this strategy is the student loans generally continue to accrue interest, even if they are in forbearance.
Do your best to get to a point where you can afford to make payments.
Eligible for student loan forgiveness
When you're eligible for student loan forgiveness, it makes sense that you wouldn't want to pay off the student loan debt too soon. If you're eligible for a student loan forgiveness program, then it's possible part or all of your debt can be forgiven.
If this is the case for your student loans, then it makes sense to pay off your auto loan first.
After all, they're going to wipe out the student loan debt anyway.
Reasons To Pay Down Student Loans
There are also a number of arguments you can make in favor of paying off student loans before focusing on auto loans.
The first is that student loans tend to be larger than car loans are.
Paying down your larger balance loans first can be psychologically rewarding.
Paying off debt, especially if you have a lot of it, is like running a marathon. It’s a long, slow process and you need to keep yourself motivated to keep yourself going.
Don’t discount the importance of feeling like you’re making progress.
Seeing the large balances on your loans shrinking month after month can make it easier to keep making payments.
Tough to erase in bankruptcy
Another big reason to pay off student loans is that they are almost impossible to get erased in bankruptcy.
With most forms of debt, you can declare bankruptcy to avoid paying or to settle the debt for less than the full amount.
Though this will ruin your credit and make it impossible to borrow money for a while, it gives you a second chance to get your financial life in order.
Student loans are different, you can only get them discharged in bankruptcy under very specific conditions.
The be exact, you must show that continue to pay off the student loan would place an “undue financial hardship” upon you and your dependents.
Bankruptcy courts use three factors to determine whether an undue hardship exists. They are:
- If you are forced to repay the loan, you would not be able to maintain a minimal standard of living.
- There is evidence that this hardship will continue for a significant portion of the loan repayment period.
- You made good faith efforts to repay the loan before filing bankruptcy.
If the bankruptcy court does find an undue hardship, your loan may be discharged, in whole or in part, or the payment terms, such as the interest rate, may be changed to your benefit.
Another reason to focus on student loans is that many student loans come with variable interest rates.
Many other types of debt, including most auto loans, have fixed interest rates.
With fixed interest rates, you know exactly how much interest you’ll pay from the time you borrow the money. Once you borrow the money, the rate never changes.
With a variable interest rate loan, the interest rate can change over the life of the loan. That means that your monthly payment can change as the interest rate changes.
If rates rise, your payment will go up. If rates go down, your payment will get lower.
You’ll never know exactly how much interest you’ll pay for the loan since it could change at any time.
If you have a student loan with a variable interest rate, you’re in a precarious position.
You might be able to handle the monthly payments now, but if rates rise, you could find yourself with a monthly payment that you can’t handle.
Even if you can handle the payments, rising rates will greatly increase the total cost of the loan.
Paying down your variable rate student loan will help you reduce the effect of interest rate increases later in the loans life.
Ideally, you’ll pay off the loan entirely before rates rise, letting you avoid the situation entirely.
If you have a lot of loans, knowing the right one to pay off first can be difficult.
Ideally, you should focus on paying off the loan with the highest interest rate first.
Otherwise, you should focus on your car loan, assuming your car is essential to your ability to continue earning an income.
If you can continue working without a car, you might instead decide to focus on paying down your student loans.