Should You Pay Off Student Loans or Credit Cards First?
Few people can say that they’re debt-free. Many rely on student loans to get an education, and some get their first credit card in college to build a credit history. But like any other type of debt, student loans and credit cards must be repaid.
In a perfect world, you would be able to strike a check and pay off both types of debt at the same time. But we don’t live in a perfect world. So you might have to focus on paying off one debt first. Which do you choose?
Why Pay Off Your Student Loan First?
One perk of student loans is that some lenders give borrowers up to 10 or 20 years to pay off their balances. This creates affordable monthly payments. Even so, the thought of carrying college debt into your 30s might leave a sour taste in your mouth.
Here are a few reasons for getting rid of this balance first.
Student loans are a bigger debt
The amount you owe in student debt can exceed what you owe on credit cards. So while credit card debt can be a nagging reminder of past mistakes, it might not be as nagging as owing tens of thousands of dollars in college loans.
A bigger loan also equals a bigger monthly payment, which can cut into your disposable cash and raise your debt-to-income ratio. This can reduce purchasing power once you’re ready to buy a home. But if you were to put all your extra income toward student debt repayment, you could possibly get rid of this debt in a few years.
This might work if you have few bills and plan to live with your parents after graduation. The best time to tackle student debt is before you take on a lot of monthly expenses.
Getting rid of your student loan also has a psychological benefit. Some people prefer paying off smaller balances first because it feels like progress. But you might be the opposite and larger debts may invoke anxiety. If so, concentrating on student loan repayment can help reduce debt-related stress.
Tough to discharge in bankruptcy
It’s far better to have credit card debt than student loans when filing bankruptcy. Filing may partially or fully wipe out some of your credit card debt. However, it’s almost impossible to discharge student debt in a bankruptcy.
To wipe out this debt, you must prove that repaying the loan will create an undue hardship. So if you’re in a position to pay off your student loan, you might take advantage of these circumstances—in case you run into hardship down the road.
Why Pay Off Your Credit Card First?
Along with arguments in favor of prioritizing student loan repayment, there are also benefits of knocking out credit card debt first.
Increase your credit score
Credit card debt is a type of revolving debt with no set repayment plan. This is unlike a student loan which is a type of installment loan with a set repayment schedule.
Credit card balances and their payment amounts fluctuate, making credit cards a riskier type of debt. As a riskier debt, credit card balances impact credit scores differently than a student loan.
Even though how much you owe (your total debt) makes up about 30% of your credit score, a high-balance student loan won’t necessarily hurt your credit score, but a maxed out credit card will.
Your credit card balances should never exceed 30% of your credit line. If you’re carrying high balances or maxed out cards, paying off these debts can boost your score within a few months.
Higher interest rates
Credit cards are convenient and can provide emergency cash. But this convenience comes with a high price. Because credit cards are risky, they often have higher interest rates.
Your student loan balance might be larger. Yet, the interest rate on your credit card could be three or four times higher than the interest rate on your loan.
What’s the Better Choice?
Prioritizing credit card repayment makes good financial sense when you can’t afford to pay off both. You’ll not only get rid of your highest interest rates first, you’ll also improve your personal credit score. This opens the door to favorable financing opportunities in the future.
Of course, it can take longer to eliminate credit card debt when you’re also juggling student loan payments. The good news is that federal lenders (and some private) give borrowers the option of reducing or suspending their monthly payments.
Student loan repayment options include:
- Forbearance. Reduces or suspends your loan payments on a temporary basis. Interest continues to accrue.
- Deferment. This program is like forbearance, but approvals are based on financial need. Your lender suspends monthly payments and you’re not responsible for paying accrued interest. The government pays the interest.
- Income-based repayment programs. Reduces your monthly student loan payment. You’ll pay no more than 15 percent of your discretionary income.
Don’t Forget an Emergency Fund
Eliminating credit card debt can feel liberating and lift a burden off your shoulder. But you shouldn’t pay off debt at the expense of building an emergency fund. In fact, many financial experts recommend having at least a 3- to 6-month reserve. Without a fund, it only takes one unexpected event to put you deeper into debt.
Let’s say you lost your job and unemployment compensation isn’t enough to cover your expenses. An emergency fund can fill gaps in your income and help you stay current on your bills.
Come up with a plan to set aside 10 percent of your income each month (or whatever you can afford). Save your tax refunds, work bonuses, overtime pay, and gift money. Deposit these funds into a high-yield savings account.
How Does Paying Off a Student Loan Impact Your Credit?
As mentioned, how much you owe makes up about 30% of your credit score, but this isn’t the only factor impacting your credit. Four other components also play into your score.
For example, the length of your credit history and your credit mix (types of accounts) make up 15% and 10% of your score, respectively. This is important information. Knowing how credit scoring models calculate scores can help you understand the impact of paying off a credit card versus a student loan.
Take a student loan, for example. Paying off this balance is a huge accomplishment and a reason for celebration, but eliminating this debt also closes the account. And if your student loan happens to be your oldest credit account, an account closure shortens the length of your credit history and causes a slight decrease in your credit score.
An active student loan, however, adds to your credit mix. As a rule of thumb, it’s never a great idea to only have one type of credit. Your credit score improves when you show a history of managing different types of credit. So if your student loan is your only installment account and you pay off this account, your credit report will lack variety. For this reason, postponing full repayment of a student loan may actually benefit your score.
How Does Paying Off a Credit Card Impact Credit?
Unlike a student loan, your credit card account doesn’t automatically close once you have a $0 balance. So while you don’t owe anything, you’ll still reap the benefits of having a credit mix, and the length of your credit history continues to increase.
Make sure you use the credit card from time to time, though. If you never use the card, your bank might close the account due to inactivity. Only charge what you can afford and pay off your balance in full each month.
Other Factors Affecting Your Credit Score
Keep in mind, your payment history also makes up 35% of your credit score. If you choose to pay off your credit card first, make at least your minimum student loan payment every month, and vice versa.
Also, only apply for additional credit when necessary. New credit makes up about 10% of your credit score. Each credit inquiry can reduce your credit score by a few points.
What You Should Know About Consolidation or Refinance
To free up extra cash for debt repayment, consider options for lowering your other expenses. Consolidation or refinance is an excellent way to get a lower interest rate and payment on a student loan.
Consolidation also works if you have many credit cards. Apply for a credit card and then transfer your balances to a single card. Look for cards offering a 0% introductory rate on balance transfers.
Student loans and credit card debt can accumulate early in life and haunt you for years, but relief is possible. If you can’t pay off both, prioritize repayment and tackle one debt at a time—just don’t forget about the importance of first building a cash reserve.