Credit Cards vs. Loans: Which Should You Pay Off First?

Credit Cards vs. Loans: Which Should You Pay Off First? article image.

To decide whether to pay off credit card or loan debt first, let your debts' interest rates guide you.

Credit cards generally have higher interest rates than most types of loans do. That means it's best to prioritize paying off credit card debt to prevent interest from piling up. Doing so can also help build credit, since reducing credit card debt directly impacts your credit utilization, one of the biggest contributing factors to your credit scores.

Here's how to figure out which debts to eliminate first—and the best ways to get rid of them, once and for all.

How to Determine Which Debt to Pay Off First

Typically—though not always—the interest rates on loans are lower than on credit cards. Personal loans, auto loans and mortgages are examples of installment loans that you pay back with monthly fixed payments over a set period of time.

In addition to interest rate, you'll see the term APR (annual percentage rate) used for installment loans and credit cards. For installment loans, the APR reflects the total cost of the loan, including fees such as origination fees. For credit cards, the interest rate and APR are the same thing.

The average credit card APR as of November 2019 was around 17%; yours could be higher or lower depending on your personal credit profile when you applied. Personal loan APRs, for instance, start at 6%, though they can reach 36%, also depending on your credit and type of loan.

To find your own credit cards' or loans' rates, take a look at your monthly statements or contact your lender if you're unsure. Start by sending extra money to the debt with the highest APR—which will generally be a credit card. That way, you'll begin cutting down on the principal balance of your debt, and you'll pay interest on a reduced amount.

Make sure whichever debt you decide to attack first, you continue paying your monthly bills on the rest of your debts to avoid missing a payment. A history of on-time payments is the largest contributor to a strong credit score.

Paying Off Credit Card Debt

If you have several credit cards, first make a list of your current balances, APRs, minimum monthly payments and due dates. That will help you figure out how to begin your payoff journey. Here are a few paths you can take:

  • Debt avalanche method: The most cost-saving payoff method is to target the credit card with the highest APR first, also known as the debt avalanche method. Using this strategy, you pay as much as you can on that card while you pay just the minimums on the rest of your cards. Once you pay off that card, you'll move to the card with the next-highest balance and employ the same strategy until all your cards are paid off.
  • Debt snowball method: You might prefer paying off small balances first, which is known as the debt snowball method. Doing so won't save you as much money as paying off credit cards with the highest APRs first, but it can be effective if experiencing a series of small wins—by paying off accounts more quickly—encourages you to continue attacking debt.
  • Balance transfer credit card: If you have good or excellent credit, you may also qualify for a balance transfer credit card. This gives you the opportunity to move multiple credit card balances to a single card, potentially at 0% APR for a period of time. You can pay off debt interest-free if you get rid of the balance by the time your promotional period ends—a crucial component of the strategy so you can avoid paying a much higher standard APR.

As an added bonus, paying off credit cards can also help improve your credit scores. The amount you owe on your credit cards compared with your total credit limit makes up your credit utilization ratio. Experts recommend limiting your utilization to 30% or less at all times to keep your scores strong, or below 7% for top scores. The more you pay down credit cards—without adding to debt—the lower your credit utilization will be.

Which Loans Should You Pay Off First?

Similar to the credit card payoff process, the best approach with installment loans is generally to focus on loans with the highest interest rates or APRs. In practice, that often means concentrating on car loans over mortgages, for example, and private student loans if they have higher rates than your federal student loans. In addition, because mortgages tend to be very large, long-term loans of up to 30 years, paying this loan off quickly might simply be unrealistic compared with paying off other, smaller installment loans over a relatively short time period.

Just like you did for credit cards, list your loan balances, APRs, monthly payments and due dates to get yourself organized. With any extra money you can spare—potentially from increasing your income or cutting back on expenses—make extra payments toward the loan with the highest interest rate first.

You can also consider strategies to lower your loans' interest rates or monthly payments. That way, you can send more money to your bills and get out of debt more quickly. Here are some options:

  • Refinance your mortgage to a lower interest rate, if you qualify for one, and put the savings toward other debts with higher interest.
  • Refinance your student loans, which is a particularly smart strategy if you have high-interest private loans. Refinancing federal student loans isn't as safe a bet: You'll lose the ability to lower your monthly payments to a portion of your income and you'll forfeit access to potentially useful forgiveness programs.
  • Opt for a debt consolidation loan, which allows you to roll multiple debts into a single personal loan with a fixed monthly payment. For debt consolidation to work, the interest rate you qualify for must be lower than the average rate of your current debts.

To make sure you can keep up with your loan payments, make a budget. You can do it yourself with a traditional spreadsheet or use one of the many free budgeting apps available online. Set up autopay on all your loan bills, either for the minimum payment or a larger amount if your lender allows for it.

Keep It Simple—and Start Now

The decision to pay off debt is a major one, and figuring out where to start can be the hardest part.

Keep it simple by focusing on your balances with the highest interest rates first, which will generally be credit cards. The same interest rate strategy applies when you're determining the best order to pay off your loans. Because this approach helps you save money on interest, you'll be able to free up cash to put toward other debts—and potentially achieve your debt-free goals sooner.

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