Which Loan to Pay Off First - Student or Car Loan?
If you have some extra cash left over each month, consider paying down one or more of your loans. Not only does paying off a loan look good to your creditors because it demonstrates good payment history, but it can also help lessen any lingering stress about your debt.
But what approach do you take? The snowball method that applies that extra payment towards your smallest debt until you pay it off? Or do you try the avalanche method that first focuses on paying off your loan with the highest interest rate? And, if you have student and car loans, which one should you focus on? The decisions can feel overwhelming.
Student loans today – what you need to know:
Whether you are considering a student loan or have one you are considering paying off, you should know that student loans are an excellent way for students to afford their continuing education. Student loans don’t require a credit history and offer much lower interest rates than private loans. And while student loan shave historically been a great choice for college students, the current pause on interest makes them that much more lucrative.
In response to Covid-19, the federal government paused payments and reduced interest rates on eligible federal student loans to 0%. The payment pause and interest rate reduction went into effect for eligible loans on March 13, 2020, and is considered administrative forbearance. For students or graduates looking to pay off their student loans, it’s critical to note that your total payment will be applied to your principal balance after you have paid any interest that accrued before March 13, 2020, and any fees for defaulted loans.
This all means that paying down your student loan now can be lucrative as the program is expected to continue through June 30, 2023.
Eligible loans in this program include:
- Direct Loans (defaulted and non-defaulted)
- Federal Family Education Loan (FFEL) Program loans held by ED (defaulted and non-defaulted)
- Federal Perkins Loans held by ED (defaulted and non-defaulted)
- Defaulted FFEL Program loans not held by ED
- Defaulted HEAL loans
Student loans typically have low interest rates
Regardless of this unique post-pandemic program, student loans typically have interest rates far lower than credit card, personal loan, or even auto loan interest rates. Presently, 5.8% is the average student loan interest rate among all existing borrowers, and for new undergraduate loans, students can anticipate a federal interest rate of 4.99%.
Auto loan interest rates are on the rise
And while student loans are seeing a bit of benefit, auto loans, on the other hand, are experiencing a hike in interest rates. The average annual percentage rate (APR)on new vehicles with auto loans climbed to 6.5% in the fourth quarter of 2022. In the third quarter of the same year, interest rates were only 5.7%, but compare that to just 4.1% at the end of 2021.
The truth is that shopping for a new vehicle right now will set you back as financing rates on new cars rise. Though interest rates can rise and lower based on the economy, the higher interest rates can cause consumers to pause and reflect on their needs for a new vehicle before purchasing. And according to Statista, we haven’t seen auto loan interest rates this high in quite a long time.
But what loan to pay off first – my student loan or my car loan?
So, with the student loan interest rate pause and the increasing rate on auto loans, what does this mean for your current loans? And, if you have the extra cash, which should you pay off first? And the answer can indeed vary; it depends. Here are some guidelines to help you make the best decision based on your financial situation:
- Before paying off your student loan or auto loan, consider your credit cards. Your credit card utilization ratio directly impacts 30% of your credit score (creditors like to see a balance of 30% or less of your credit limit). So, if you have a high-interest-rate credit card and are over the recommended utilization, pay down your credit card first. Just don’t forget to keep making your monthly payments on your student loan or auto loan while you do so.
- Next, look at the interest rate on your auto loan vs. your student loan. Remember that federal student loans often have low fixed interest rates, which could be below the rate you’re paying on your auto loan. And with the current pause on student loan repayments, you may be able to stop making payments for the next several months temporarily.
- Consider the value of your automobile. While we all love a nice ride, cars depreciate fast. Your car may depreciate in value by 15 to 25% each year you own it until the car is five years old. If you want to trade in your car and take out a new auto loan for a new car or new-to-you vehicle, you may have to offset the negative equity as part of the process (making that newer car much more expensive).
In a nutshell – pay off your auto loan first
For most borrowers, paying off their auto loan before their student loan can make the most sense (after your credit card balances are in line). Paying off your auto loan (or refinancing for a lower rate), can help you save money in interest and set you up for success if you are ready to purchase a new or newer car and want to find the best auto loan for your needs. The last thing you want is to roll that negative equity from your previous vehicle into your new auto loan.
Deciding which loan to pay off first takes a bit of homework and forward-thinking. But remember that you can never get those interest dollars back. So, the sooner you pay off your auto loan, the more money you can keep in your pocket or apply to your next down payment. And if you need help with a refinance, our team is here to help!