Student Loan Debt vs. Credit Card Debt: What Should I Pay off First?
by Catherine Tansey
If you’re like most Americans who graduated from college in the last 15 years, you have student loan debt. The total student loan debt in the country tallies over $1.6 trillion, the second highest debt category only to that of mortgages.
A decision that helped send you to college is likely one you’re still paying for, perhaps in more ways than one. Maybe you’ve put off big life milestones like buying a home or starting a family because you still carry a hefty student loan balance. The frustrations of that nagging debt can make you just want to get rid of it — but if you also have credit card debt, paying off your student loan debt first isn’t your best option.
Prioritizing student loan debt over credit card debt is costing you. For one, the interest rate is likely much higher, and therefore the debt is more expensive over time.
“I would say that, unless somehow your credit card interest rate is lower than your student loan interest rate, it almost always is better to focus on credit card debt first,” said Simon Brady, CFP®, CDFA®.
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The federal student loan debt interest rates are set by congress, and between 2010 and 2020 rates varied from 3.4% – 6.8%. Conversely, as of May 2020 the average APR for a new credit card was 15.99% — the lowest it’s been in years. Keep in mind that most people’s credit card debt is carried at a much higher interest rate.
Secondly, credit card debt affects your credit score more than student loan debt. Student loan debt is what’s known as installment debt, or debt that is paid back in regular installments over a fixed period of time. Credit card debt is what’s known as revolving debt, or debt that allows you to continue to borrow on that existing credit line.
Aproximately 30% of your credit score is calculated from your credit utilization rate — a figure that comes from revolving credit and debt, not installment debt.
Paying off credit card debt first helps bring down your credit score and save on interest.
Compound interest is interest that’s calculated on the principle, as well as all the other interest that accrued on the debt. It’s “interest on interest.”
“The very same math that makes compounding so compelling when you are investing becomes an evil twin when it comes to debt,” said Brady.
Consider the following examples:
Note that the interest on the credit card debt example exceeds the principle amount. The borrower will have paid more than double the principle by the end of 10 years.
“Not only does the debt grow each year, but the rate at which it grows increases every year, even if the interest rate does not change. This is how debt, particularly high interest debt where the effects are magnified, can so rapidly spiral out of control,” said Brady.
Brady likes to frame it in the inverse to his clients.
“Making $1,000 of 25% APR debt go away is exactly the same as investing $1,000 and making a 25% guaranteed rate of return, tax-free,” he said. But he points out that such a tax-free guaranteed investment does not exist anywhere.
Conversely, “Making $1,000 of 4% APR debt go away is exactly the same as investing $1,000 and making a 4% tax-free rate of return,” which he notes, is a possible rate of return.
If approached with these two investment offers, you’d pick the 25% rate of return option. every. single. time. Yet debt can cloud your judgement. By choosing to pay off much lower interest student loan debt ahead of higher interest credit card debt, you’re actually selecting the 4% option.
Don’t let emotions rule your financial decisions. Make a plan and stick to it, and consider seeking professional advice when you’re ready to level up your financial planning.
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