When you have lots of different debts to repay, you’ll have to prioritize which you should focus on paying off first in your quest to become debt-free.
Sometimes the answer is obvious, such as when you have high-interest debt like credit card debt that should always be paid off before loans at a lower rate. In other cases, however, the decision is less clear-cut and will depend on the specifics of your situation.
One of those cases is when you’re trying to decide between paying off student loans or an auto loan first. If your student loans are private student loans, it sometimes makes sense to focus on paying them off before the loan for your vehicle, depending on the loan interest rate and terms. But if you have federal student loans, the right choice is usually to pay off your auto loan first. However, in any situation, you need to consider the specifics of your loan and your overall financial position to figure out what’s right for you.
To help you decide what’s best, here are a few key things you need to know.
Paying off federal student loans vs. paying off an auto loan
When you have federal student loans, there are many reasons why it makes sense to keep those loans until you’ve retired other debts, including auto loans. Paying off federal student loans early when you have a car loan likely doesn’t make sense because:
- Federal student loans often have low fixed interest rates, which could be below the rate you’re paying on your auto loan. And the interest is sometimes subsidized if you have a Direct Subsidized Loan. This means the government pays interest so it doesn’t continue to accrue while you’re in school or if you’ve put your loans into deferment. Auto loans, of course, don’t have subsidized interest -- and the rate you’ll pay is probably higher than on federal loans.
- Federal student loans give you the chance to pause payments. Deferment and forbearance make it possible to temporarily stop making payments on loans in a number of situations, such as if you go back to school or you’re facing financial hardship. Auto loan lenders don’t let you stop making payments -- they’ll repossess your car if you fail to pay.
- Federal student loans have very flexible repayment options. You could choose a standard 10-year repayment cycle with fixed payments that don’t change; you could choose a graduated repayment plan so payments rise as your income does; or you could choose from various income-based plans that base payments on your earnings. You have the option to change your plan over time if you need to. And if you use a Direct Consolidation Loan to consolidate student debt, you could have as long as 30 years to pay your debt. Auto loans don’t provide this flexibility -- you agree to monthly payments up front, your repayment term is usually much shorter than for federal loans, and you can’t change your repayment terms without refinancing to a new loan.
- Federal student loans can sometimes be forgiven. If you are on an income-based plan and make payments over 20 or 25 years -- depending which plan you’re on -- the remaining loan balance could be forgiven. Or, if you work in an eligible public service job, you may be eligible for Public Service Loan Forgiveness after 120 monthly payments. Auto loan lenders, unsurprisingly, don’t forgive your loan.
- You can take a tax deduction for student loan interest. Unless you make too much money, you’re able to deduct up to $2,500 in student loan interest from your taxes each year. You don’t have to itemize to be eligible to claim this deduction. Auto loan interest isn’t deductible for a loan for your personal vehicle, so you don’t get this tax savings for paying interest on your car loan.
Because you have so much more flexibility in payments, get a tax deduction for interest, and are likely paying a lower rate on your student loans than your auto loan, it would make no sense to pay off federal student loans before your car loan. Focus on paying your car and other consumer debt off first and only then should you consider whether early student loan payoff is a smart choice.
Paying off private student loans vs. paying off an auto loan
While it’s clear an auto loan should be paid off before federal student loans, the decision isn’t so straightforward when you have private loans. Private loans don’t come with all of the borrower protections federal loans have, and the interest rates vary depending on the specific loan you’ve taken out.
To decide if you should pay off a private student loan or an auto loan first, ask yourself these questions:
- What interest rate are you paying? If you’re paying more interest on your private loan than your auto loan, focusing on paying off the private loan ASAP could make sense.
- Do you have a cosigner on either loan? It’s really common for students to need a cosigner to get a private student loan. Sometimes people have cosigners for car loans, too. If you have a cosigner on one loan but not the other, working on paying off the loan with the cosigner is sometimes a good idea because when you retire the debt, the cosigner will no longer be on the hook for it. Your cosigner did you a favor, so getting your debt off their credit report ASAP is a nice thing to do.
- Are you taking a tax deduction for private student loan interest? Private student loan interest should be deductible on your taxes, just as federal student loan interest is. But remember, you can’t take this deduction if you make too much money. And you can only deduct a maximum of $2,500 in interest annually. If you’re already earning the full deduction with federal loans, then you won’t lose it by paying off your private loans early. But if you’re deducting the interest you pay on your private loans, it may make more sense to pay off the auto loan -- with its non-deductible interest -- first.
- Are you underwater on your car? If you owe more than your car is worth, this can become a problem. Many lenders require gap insurance to pay the difference between what you owe on the car and what your car is worth in case the vehicle is totaled or stolen. If you don’t have gap insurance, you could be on the hook to pay for a car you no longer have if something happens to it. If you want to trade in your car soon and you’re underwater, you’re also going to have an issue. You’d either need to come up with the cash to pay off any excess balance on your loan or would need to roll that amount into your new loan -- so you’d immediately owe more than the new car is worth.
You should take all of these issues into account and decide what makes sense for you. Usually, you should pay off whichever loan has a higher rate, but if you’re getting a deduction for the interest on your private student loans, then paying off the auto loan first could make sense. If you owe more on your car than your car is worth, you may also want to focus on paying it down so you don’t end up having a problem if you want to trade it in or if something happens to the vehicle.
Make an informed choice about which debt to pay off first
Ultimately, every decision you make about your money is a trade off and there’s always an opportunity cost. By considering the big picture, you can choose the course of action that makes the most sense for your financial situation.