Interest Rates: Deciding Which Debt to Tackle First

December 2, 2014

If you have student loans and credit card debt, the blanket answer for getting out of debt is to first pay off the credit card, then attack the student loans. But is that always the best advice? The reason people generally suggest to pay off credit cards first, is because usually credit card interest rates are significantly higher than student loan interest rates. What if you’re like me and your student loans are higher than your credit cards? Then does it make sense to pay off the student loans first? Let’s go through the questions you might want to ask yourself in that situation.

Do I have an emergency fund?

Every time you make a payment on your credit card, your available credit increases. If you pay $100 toward your credit card, you will have $100 more in credit to use if you needed it, less interest charges. The same doesn’t happen with a student loan. There is no credit to draw from on a student loan. So if you paid $100 toward your student loan, and you lose your job, you can’t access that $100. With a credit card, at least some of that money you paid will be available to you in the form of credit.

Do I need my minimum payment to decrease?

This is important to know if you are strapped for cash. Spending a work bonus or unexpected windfall to pay off debt is great for the long term. Just know that, as far as student loans go, the minimum payment isn’t going to be any lower the next month. This can be a deal-breaker for people struggling to make ends meet. If you want to see your minimum payment drop, apply that bonus to a credit card.

Is my job stable?

Most people know that you can declare bankruptcy and likely eliminate your credit card debt -- but not student loans. What you may not know, is that in the event of job loss or a decrease in pay, you may be eligible to temporarily suspend or lower the monthly payment of your student loans.

In the event of a job loss, depending on the type of student loans you have, you may be able to put your student loan minimum payments on hold by being granted a deferment or forbearance. A deferment is a suspension of your payment up to a maximum of three years. If your loans are subsidized, they will not accrue interest during the deferment. If you don’t qualify for deferment, look into forbearance. The maximum period of suspension is 12 months, and your student loans will continue to accrue interest.

Another option is to look into an Income-Based Repayment plan. The minimum payment will be based on your salary, though your balance will continue to accrue interest, meaning it will take longer to pay off the loans. This is geared for those new college grads that struggle to pay their necessary expenses and student loans every month.

Credit cards typically don’t offer the same options. Regardless of your employment status or salary, credit card companies expect their minimum payment. This is one reason, if you’re at all uncertain about your job stability, that paying off your credit cards before your student loans makes sense.

Can I get a tax break on the interest?

You’ll often hear people say that paying off credit cards before student loans is always a good idea because of the tax deduction. If you weren’t aware, the interest you pay on most student loans is tax deductible. The student loan interest deduction is an ‘above the line’ deduction. For example, if you paid $1,500 in interest in 2014, you will be able to reduce your taxable income by $1,500, which will decrease the amount of taxes you owe. This is in addition to the Standard Deduction, which this year is $6,200 if you are filing single.

Let’s use the example of Maria, a recent college graduate hired by a local school district. Her salary as a first year teacher is $38,117. She has $27,500 in student loans, about average for a new college graduate, and paid $1,870 in student loan interest in 2014.

This is what her taxes for this year look like with and without the student loan interest deduction:

Without Student Loan Interest Deduction With Student Loan Interest Deduction
Salary $38,117 Salary $38,117
Standard Deduction -$6,200 Student Loan Interest Deduction -$1,870
Taxable Income $31,917 Standard Deduction -$6,200
Taxes Due $4,334 Taxable Income $30,047
    Taxes Due $4,053
    Difference $281

Maria paid $1,870 in student loan interest and by using the deduction she reduced her taxable income by $1,870. As a result, she saved $281 on her taxes. This doesn’t happen with credit cards; you can’t deduct the interest you pay when filing your taxes.

Paying off debt can be difficult, and which debt to target first can be a tough call. For some people, decisions on debt management are emotional, so they may pay off the lower balance first because that feels good. For others, it is strictly a financial decision, so they may pay off the card or loan with the highest interest rate first. By looking at your options and finding and then sticking to the strategy that sits best with you, you can take away some of the stress from this process.

This post was written by Aaron Sherman, a field education representative for Colorado PERA. Would you like to write a guest post for The Dime? Email us at dimecontact@copera.org