Should You Pay Off Car or Student Loans First?
Weighing car and student loan repayment? Compare interest rates, credit impact, and potential benefits to make the best financial decision for your situation.
Deciding whether to pay off a car loan or student loans first can significantly impact your finances. Each type of debt carries different terms, risks, and benefits that should be carefully considered.
Several factors influence which loan to prioritize, including interest rates, collateral requirements, repayment terms, credit score effects, tax considerations, and potential forgiveness options. Understanding these differences will help you make a sound financial decision.
Interest Rate Differences
Interest rates determine how much you’ll pay beyond the principal balance, making them a key factor in deciding which debt to tackle first. Car loans generally have lower interest rates than student loans, but this varies. Federal student loans issued after July 1, 2023, carry fixed rates of 5.50% for undergraduates, 7.05% for graduate students, and 8.05% for PLUS loans. Auto loan rates depend on credit score, loan term, and lender, typically ranging from 5% to 10% for borrowers with good credit.
Variable interest rates add complexity. Most federal student loans have fixed rates, but private student loans and some auto loans may have variable rates that fluctuate with market conditions. A private student loan with a variable rate could become more expensive over time. Comparing the annual percentage rate (APR), which includes interest and fees, provides a clearer picture of borrowing costs.
Loan Collateral Issues
How a loan is secured affects the financial risk of keeping it open versus paying it off early. Auto loans are secured by the vehicle, meaning the lender can repossess it if payments are missed. Losing transportation can impact your ability to work and manage daily life. Student loans, by contrast, are unsecured, so no asset can be seized for non-payment.
Because car loans are backed by collateral, lenders often require full coverage auto insurance. Paying off the loan early could allow you to reduce coverage, depending on state laws and personal risk tolerance. Vehicles also depreciate quickly, often losing significant value within the first few years. If the loan balance exceeds the car’s market value—known as being “underwater” or “upside down”—selling or trading in the car may not fully cover the remaining debt.
While student loans cannot be discharged through repossession, defaulting can lead to wage garnishment, tax refund seizures, and long-term credit damage. Federal student loans offer protections such as deferment, income-driven repayment plans, and forbearance, allowing borrowers to temporarily reduce or pause payments. These options do not exist for car loans, where missed payments can quickly lead to repossession.
Loan Term Variations
The length of a loan affects how much you’ll pay in interest and how it fits into your financial strategy. Car loans typically range from 36 to 72 months, though some extend to 84 months. Shorter terms mean higher monthly payments but less total interest, while longer terms reduce monthly costs but increase overall expenses. Student loans often span 10 to 30 years, making them a long-term financial obligation.
A car loan’s shorter repayment period means paying it off early frees up cash flow more quickly, allowing funds to be redirected toward savings, investments, or other financial goals. Student loans, with their extended timelines, can create a persistent burden, particularly if spread across multiple lenders with varying terms. Consolidation or refinancing may simplify payments, but these options can come with trade-offs, such as losing federal protections or extending repayment further.
Credit Score Factors
Debt repayment affects credit scores through payment history, credit mix, and debt-to-income ratio. Payment history is the most influential component, accounting for 35% of a FICO score, meaning that consistently making on-time payments on any loan is beneficial. However, closing an account can impact overall credit health.
Car loans are installment accounts, and once paid off, they are closed, reducing the diversity of active credit lines. A well-managed mix of credit types, including revolving credit like credit cards and different types of installment loans, contributes positively to a credit profile. If a car loan is your only installment debt and you pay it off early, you may see a temporary dip in your score due to the reduced credit mix. Student loans, also installment loans, tend to remain open much longer, contributing positively to credit age, which makes up 15% of a FICO score.
Tax Implications
The tax treatment of loan payments can influence which debt is more advantageous to pay off first. Unlike car loans, which offer no tax benefits, student loan interest may be deductible, reducing taxable income for eligible borrowers. The student loan interest deduction allows up to $2,500 in interest payments to be deducted annually, provided the borrower meets income requirements. For 2024, the deduction begins to phase out at a modified adjusted gross income (MAGI) of $75,000 for single filers and $155,000 for married couples filing jointly, with full phase-out at $90,000 and $185,000, respectively.
This deduction is particularly beneficial for borrowers in higher tax brackets, as it directly lowers taxable income rather than requiring itemization. However, it only applies to interest paid, not principal, and is unavailable to those who exceed the income limits. Since car loan interest is not deductible, paying off an auto loan does not provide any tax advantage. Borrowers who qualify for the student loan interest deduction may find it financially beneficial to keep student loans open longer while directing extra payments toward other debts.
Forgiveness Provisions
Unlike car loans, which must be repaid in full, student loans may qualify for forgiveness programs that eliminate some or all of the remaining balance. These programs are primarily available for federal student loans and depend on employment type, repayment history, and income level.
Public Service Loan Forgiveness (PSLF) cancels loan balances after 120 qualifying payments for borrowers working full-time in government or nonprofit jobs. Income-Driven Repayment (IDR) plans also provide forgiveness after 20 or 25 years of payments, depending on the specific plan. Recent changes under the Biden administration have expanded eligibility for IDR forgiveness, particularly for borrowers with older loans or those who have made partial payments. The SAVE Plan, introduced in 2023, lowers monthly payments for many borrowers and accelerates forgiveness for those with smaller balances.
Private student loans do not qualify for federal forgiveness programs, and borrowers must rely on refinancing or negotiated settlements to reduce their debt burden. Car loans also lack any form of forgiveness, meaning the full balance must be repaid regardless of financial hardship. This distinction makes student loans a lower priority for some borrowers, especially if they anticipate qualifying for forgiveness.