Pay off your car loan before other debts?

If you have several debts that need paying off, there are a number of basic strategies to accomplishing this. Each one has its own pros and cons. I'll talk about three that have made the rounds, and introduce a fourth that is a bit different.

Make extra payments on the debt with the lowest balance first. This is the method advocated by Dave Ramsey and his followers. The main advantage of this method is a psychological one: it eliminates one of those bills the fastest, and provides positive dragon-slaying feedback the most quickly. The main disadvantage is that it does not take the interest rate of the debt into consideration, and hence the amount of money needed to pay off all of the debt is higher, and it takes longer to do so.
Make extra payments on the debt with the highest interest rate first. This is a straight number-crunching, cost-minimizing approach. The advantage of this method is that the least amount of interest is paid. The main disadvantage is that the first “dragon slaying” is farther off, and motivation to continue has to come within.
Pay only the minimum amounts on the debts and stash as much cash as you can. This method isn't really a debt reduction strategy but more a protective mechanism, and was recently endorsed by Suze Orman. The key idea is that times are especially uncertain these days, and having a bolstered emergency fund is more valuable than paying off debt aggressively, because a bolstered emergency fund buys you time. While this is being done, of course, the debts remain, and the interest expense is the costliest.
Accelerate payments on the debt that has the shortest fuse. This is a bit different strategy, but it may have some merit. Liz Pulliam Weston's article on how to not pay your bills discusses ways to minimize the damage of having too much month relative to your paycheck. She lists the debts that have the shortest fuses — the time period of delinquency after which bad things happen like repossession, credit score hits, and foreclosure. Of the debts she lists, car loans have the shortest fuse. Lenders can repossess the car the next day in some cases. Mortgages and home equity lines of credit are next, then unsecured debt, and finally student loans.

So, might it make sense, given the choice, to try to eliminate those short-fuse debts first? It could even be argued that things would really fall apart quickly without a vehicle. Job loss could be imminent if you couldn't show up for work, no?

In any case, doing something proactive is better than doing nothing beyond the minimum, in any case. Hunker down!

Thanks to Gather Little By Little for including this post in the Carnival of Personal Finance.

7 thoughts on “Pay off your car loan before other debts?”

I think quick wins are of utmost importance not only for the psychogical advantage of quick wins, but also to establish and develop good debt-reduction behavior.

To me, I would only consider moving up a car payment in my debt snowball after a few quick wins with my lower balances. And the reason I would do it would have nothing to do with how fast it could be repo’d. Rather, eliminating a car payment usually frees up more money each month to add to your snowball than other debts would, and reduces the amount of minimum payments you have to come up with each month.

Great description of options.
I would only make the point that student loan debt collection, especially the fed. program, has the ability to do things that can really hurt, ie holding tax refunds, that only the federal government can do. So best to use the hardship deferral option rather than just not paying, if at all possible, when dealing with those loans.

mbhunter – thanks for showing the variety of options. Goes to show you are genuinely trying to help your readers.

However if things are so tight that you find yourself weighing your car note against your financial survival wouldn’t you seriously consider dumping the car and the note for a clunker that you can pay cash for?

I always advise the same – you should always pay off the debt with the lowest balance first because when you do, it will make you feel like you are really making progress as opposed to the bigger debts where it can take years to make any impression on the balance.
Nice article.

@LeanLifeCoach: If that’s possible, sure. But if you’re already upside-down on the car loan (likely) then upon selling the car you’d need to make up the difference to have the lien released.

@Dr Dean: True. I think the main “spin” I was going for (and Liz Weston as well) was that some loans have a shorter fuse on them. If you miss your car payment by even one day, your car can be repossessed. Bad things can happen with a student loan, but it takes months, not days.