Which loan should I pay off first?

[Travis-84]

I have 3 loans, 2 student, 1 car.  I'm really struggling with which one to pay off first.

Loan 1, student: 10,000, interest rate of 4% after interest tax deduction.

This is the loan I have been paying off with all my extra money.  Since I'm paid ahead, no payment is due until 2014.

Loan 2, student, 1800, 3.375% after interest tax deduction.  Minimum payment is 50.00.  I always keep this loan paid one month ahead, so my next payment is due 10/1, but I'll make it on 9/1, so I never have to worry about missing a payment.

Loan 3, auto.  3.99% apr.  Balance is 2800.  Payment is 115 a month.  I expect the car to last 5-7 more years. 

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I took out my auto loan in October of last year, so it is less than 1 year old.  The reason I don't like the idea of paying it off too quicly is I'm worried that when I need a car a few years down the road, (maybe a 20k loan), I might not get 0% interest rates because of my lack of auto loan experience.  This is my only auto loan I've ever had.  Do you think carrying the loan for 2-2.5 years will help me get better financing on a new car down the road, or does it really not matter?  I know the standard response given is that getting out of debt is more important than FICO scores, and I agree with that, but I have a choice in which debt to pay off.  (I pay around 500 a month towards debt)

[haulingthescoreup]

Good question! Conventional wisdom is to keep a loan open for at least one year, but whether there's anything to that or not, I don't know.

But surely you're not going to drag your auto loan payment out over 5-7 years, right? So you still won't have an open loan when you go shopping again.

It sounds like you're so on top of things that when the time comes, you'll have excellent credit whether or not you have a lot of auto loan history, so it might not really matter. Also, if you get your financing through a credit union, they might not pull an auto-enhanced score anyway. I know that our CU always pulled a straight Beacon 5.0 (aka the EQ FICO that you get here.)

The loan should stay on your reports for 10 years after you close it, so that good history will still be there.

I guess my thought would be to wait until after October (one year after opening), and then pay it off. Although one question, do you already have an emergency fund? Even though I'm allergic to paying interest, it's more important to have an emergency fund paying some whopping 0.20% interest and make car payments, than to be car-payment-free but strapped for cash after an unexpected expense.

[Travis-84]

Thanks for the reply.  My auto loan is a 3 year loan, so unless I miss a few payments, It will be paid off in October 2014.

My emergency fund is about 5,500 right now.  Its a far cry from what I would like it to be, but it is headed in the upward direction.  I should be able to have my emergency fund at 8k by the end of the year, which would give me 6 months of (bare minimum expenses), IE beans and rice, not making any student loan payments, paying minimum on my car loan, etc.  I'm going to continue saving and by sometime next year, I should be able to have 6 full months of expenses.

[bobebob]

Question: Are they applying your extra payments on your 4% Student loan as paying ahead versus paying down the principal?  If you want to save interest, you have to make sure that the extra money you pay goes against principal.

As to which you should pay off first, it depends what your goals are:

1. If you want to save the most interest:

   A. take the $500 extra and put it against the car loan pay that off @ $615/mo = gone in 6mo

   B. once car loan's gone roll that up and put it towards the $1800 balance student loan and pay off @ $665/mo = gone in 3 mo

   C. When that one's gone roll it all towards the $10k student loan. = gone in 11 - 15mo (dep on whether you have $665 going towards it or say it's regular payment in addition - 11mo assumes the $665 plus a reg payment of $250 which is a guess since you didn't list the reg payment on the 10k)

Worst case, you are debt free in 24mo.  This will save you a nice chuck of interest.

2. if you want to maximize your credit rating:

Paying down debt will usually increase your scores.  But I'm not sure if leaving an auto loan open longer or paying off the debt quickly will raise your score more.

My personal reaction would be to erase the debt quickly and let the FICO fall where it may.

3.  If there is a possibility of job loss and/or bankruptcy later:

Pay off the student loans first as these will not be discharged with a bankruptcy and hang around your neck until paid off.  The car loan would be discharged.

In all, I would go with the first one.  It gets rid of your debt quickest and saves you the most interest.  It also will raise your score since you will be reducing debt.

My guess is that if you have little debt your score will be high enough to get good rates on your future car loan needs. BUT, if you expect the car to last at least 5 more years that means that you could save up AT LEAST $23,940 during the 3 additional years your car will be good after you've paid off the loans!  Hey - no need for the $20k car loan!

[stan_the_man]

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@haulingthescoreup wrote:

I guess my thought would be to wait until after October (one year after opening), and then pay it off. Although one question, do you already have an emergency fund? Even though I'm allergic to paying interest, it's more important to have an emergency fund paying some whopping 0.20% interest and make car payments, than to be car-payment-free but strapped for cash after an unexpected expense.

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+1

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@bobebob wrote:

3.  If there is a possibility of job loss and/or bankruptcy later:

Pay off the student loans first as these will not be discharged with a bankruptcy and hang around your neck until paid off.  The car loan would be discharged.

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 +1

One more relavent question is whether you plan to apply for a real estate loan before the car would normally be paid off. Since mortgage companies look at the ratio of your debt payments to your income to determine if and how large of a loan you qualify for, you may want to pay off the auto loan first because it has the largest required payment for relative to the two loans that you would be in position to payoff.

Also, if you haven't already, check with your student loan lender to see if they provide any kind of interest rate reduction for setting up auto payment plans. Many lenders give a 0.25% interest rate reduction by simply authorizing them to auto debit your payment each month. For DW the interest rate reduction only applies to her unsubsidized loans.