Let’s say you have $ 50,000 in student loan debt and $ 5,000 in credit card debt. If you get a big tax refund this year, where should you invest the extra money?
The short answer is that credit card debt should generally be your top priority, but like most personal finance topics, there is no one answer. If you find yourself in the privileged position of having extra cash to use for debt repayment, here’s a rundown of what you should consider.
Good Debt Against Bad Debt
Many financial planners, including myself, divide debt into two main baskets: good debt and bad debt. I would even go so far as to divide it into three levels: excellent, good and bad.
Awesome Debt refers to debt that is relatively cheap (low interest rate) and is used to acquire things that are likely to increase in value over time. Think about mortgages: Not only is mortgage debt generally low in interest compared to other types of debt, it also allows you to buy an appreciating asset – a home. In fact, mortgages are such a useful form of debt that many financial planners advise clients to use a mortgage when buying a home, even if they can afford to pay cash for the purchase. With their low interest rates and long repayment terms, mortgages offer you the flexibility to put your cash on hand for productive purposes, such as investing for retirement.
Good debts have two main characteristics: they are relatively unattractive and allow the acquisition of a good that is useful but unlikely to increase in value. An auto loan at a reasonable interest rate is an example of potentially good debt because it allows you to buy a car, which allows you to get to and from work. I would also put student debt in this category. As long as you graduate, you will have an asset that will increase your earning power for the rest of your life.
Wrong debts have high interest rates, are not used to acquire a useful asset, or both. The best example is credit card debt. The average US credit card APR is around 18% right now – around four times the average mortgage rate.
The point is, when you have extra cash to pay off your debt, it’s usually a good idea to start with the “bad debt” category. This is why a credit card balance should generally be your first priority.
Interest rate considerations
Perhaps the most obvious consideration in deciding which debt to pay off first is the interest rate you pay on each one.
In other words, if your student loans are around 6% interest and you have 24% APR credit card debt, deciding where to channel your extra money should be a no-brainer. As a rule of thumb, it’s a good idea to start with your most significant debts and reduce them gradually.
For example, let’s say you have a mortgage at 4% interest, a car loan at 7.5%, student loans at 6%, and a small credit card balance at 18%. In this case, all the money you have available to pay off additional debt (after you’ve made the minimum payment on each loan, of course) should first be used to pay off your credit card debt. If that’s done and you still want to use your extra cash to pay off your debt, your car loan might be the right solution, as this form of borrowing costs you more than either of the others. dollar basis.
Where it gets a little less clear is when you have APR promotional offers with your credit cards. If you have $ 5,000 in credit card debt, but your account has Promotional APR 0% for the next 18 months, it may be a little easier to justify paying more on your student loans. These situations should be assessed on a case-by-case basis, but the general rule is that if and only if you will be able to pay off your credit card debt before the higher interest rate kicks in, it’s okay to use your extra money for other forms of debt repayment like student loans.
Different types of loans affect your credit score differently
Another important thing to mention is the effect of different types of debt on your credit score. There are two main types of debt you can have: revolving debt and installment debt.
Credit card debt is an example of revolving debt. Revolving debt, in plain English, is a line of credit that you can choose to use or not to use and that has no set repayment term. On the other hand, student loans are a form of installment debt where you make a certain monthly payment and your loan will be fully paid off within a certain number of months. (Note: With income-based repayment and forgiveness programs, student loans are a bit more complex than most other types of installment loans, but they still fall into the same general category.)
Regarding your credit rating, your debts are included in the “money you owe” category, which represents 30% of your debt. FICO® score. This includes information such as your credit card balances against your limits and your installment loan balances against your original principal.
All other things being equal, installment debt is generally viewed more favorably by the FICO formula than revolving debt. In other words, a $ 10,000 student loan that you still owe $ 9,900 will look better for scoring purposes than a $ 10,000 credit card that is nearly depleted.
By prioritizing credit card repayment, not only could you save a lot of money on interest, but you could also increase your credit score faster.
Will you be eligible for a loan forgiveness?
Lastly, if you plan to qualify for a student loan forgiveness in any form, it’s usually not a good idea to pay off your loans any faster than you have to. To cite the most common examples:
- If you have federal direct loans and you work for 10 years in the public service while making payments on your loans, you may be eligible for the public service loan forgiveness, or PSLF.
- If you teach for five consecutive school years in a low-income school, you can potentially get up to $ 17,500 for your student loan cancellation.
- If you repay your loans through an income-based repayment plan like Pay As You Earn or Income-Based Repayment, any remaining balance is automatically written off after 20-25 years of payments, depending on your repayment plan and the type of loan.
In most of the cases
The main thing is that in most Paying off credit card debt is a better financial decision than pay extra for student loans. However, as with most financial questions, there is no perfect answer here. For example, you might have little or even no interest on your credit card debt and you are on your way to paying it off in full before the promotional period ends.
That said, in most cases, it’s hard to justify paying off your student loans any faster than if you have unpaid credit card debt.