When you are juggling multiple debts, it can be confusing to know which ones to pay down first. A good rule of thumb to follow is to focus on eliminating debt with the highest interest rates first. When deciding whether to pay off your car loan or your credit card first, it's almost always smarter to knock out the credit card debt completely.
What's more, installment loans—like car loans, student loans, and mortgages—are paid in equal amounts each month. Unless you are behind on making your monthly payments, focusing on eliminating variable credit card debt is almost always going to save you both money and improve your credit scores.
Why You Should Focus On Paying Down Credit Card Debt
Typically, your credit card debt will carry a higher interest rate than a car loan—a 60-month new car loan is currently averaging 4.51%, while the average variable credit card interest rate is 16.79%. That means the longer you carry credit card debt, the more money you will pay in excess of the principal you borrowed—much more so than your auto debt.
Another advantage to paying off credit card debt is that as it goes down, you reduce your credit utilization ratio—the amount of revolving credit you use relative to the amount you have available to you—thus bringing up your credit score. Your credit score depends on how well you pay your debts on time, but also on how low your credit utilization ratio is.
As you whittle away at credit card debt, your utilization ratio goes down; you will see your credit score climb as a result. On the other hand, if you pay off a car loan, your utilization ratio is not affected, because it is calculated based on variable revolving debt from credit cards and home equity line of credit.
If you have outstanding balances on multiple credit cards, it may also make sense to consider consolidating that debt onto one card through a balance transfer. This could save you money because you could qualify for a lower interest rate. It could also make it easier to keep track of bills and pay them on time.
Always Pay Your Debts on Time
You should not pay down your credit card debt at the expense of skipping car payments or not making them on time. Make sure you are sending the minimum monthly payment for your car loan at the due date every month (or better yet, schedule automatic payments). The bottom line is that you have to pay the minimum due on all your debts every month, or risk defaulting on your loans and putting your credit scores in serious jeopardy. You also risk losing collateral—like your car—that is used to secure your loan.
So budget how much you need to pay for your necessities, like rent, groceries, and monthly loans, and then direct any excess to pay down credit card debt as soon as possible.
Exceptions to the Rule
Of course, there are always unique situations that might warrant you paying off a car loan first. For example, say you only have $1,000 left on your car loan but carry $10,000 of credit card debt. Sometimes it's psychologically helpful to eliminate a small debt completely before focusing on another. (And then you can redirect your monthly car payment amount to accelerating your credit card payoff.)
However, consider how applying that $1000 you used to pay off the car loan might have boosted your credit scores and saved you money in the long run if you applied it to the credit card balance.
Another reason you might want to eliminate your auto loan is so you own your car outright, which can make it easier to sell or trade in your vehicle. You may also have access to lower auto insurance premiums because certain lenders can require costly comprehensive coverage during the duration of the loan.
But just remember, you could also be subject to prepayment penalties, which are baked into certain auto loans. Such penalties required the borrower to pay a fee, which is usually a percentage of the outstanding balance if you choose to pay off the loan before the loan period is up. So check the terms of your auto loan to avoid any additional costs.