Dear Talking Cents Guy,
I graduated from an expensive liberal arts college five years ago, and I’ve been struggling to pay off my student loans. I worked a string of low-paying entry-level jobs and to make my student loan payments (I could only defer them for so long), I had to prioritize my funds and ended up with thousands of dollars’ worth of credit card debt. This, of course, trashed my credit score.
Thankfully, I recently started a new job that pays significantly better than my previous jobs, and I am more financially secure. With my new income, does it make sense to pay off my student loans so that I don’t have this cloud hanging over me for the next ten years? Or does it make more sense to pay off my credit card debts? I’d like to improve my credit and think about settling down with my girlfriend in the next few years.
-Newly Employed, Still in Debt
Dear Newly Employed,
Congratulations on your new job! I definitely see the appeal in wanting to pay off your student loan debts. Paying off the balance in full saves a bundle of money in interest, while freeing up some monthly cash flow. You should also check to see if your student loans are coming with fixed or variable rates. If variable, you may want to pay those off earlier, because those rates can increase and cost you more money in the long run. If the rates are fixed, then what you’re going to pay is locked in and you can budget for it.
Though the idea of being loan payment-free is certainly attractive, you’ll want to look at the interest rates on your credit cards and compare. It’s a fair bet that your credit card debt is at a much higher interest rate than your student loans. My student loans, for example, were at 6.5 percent interest, and yours are probably somewhere around that. But most credit cards are at 15 percent or higher, and that interest adds up really fast and tends to snowball. You may want to contact the creditor to see if they have an internal program that will lower the current interest rate, as this will help you pay off the debt sooner.
Also, because student loans are considered installment debt (fixed payments for a specific period), it affects your credit score less than the revolving debt of credit cards. Paying off your credit card debt will have a more positive impact on your credit score than paying off your student loans. Be sure to continue paying the required student loan, however. If you default on your loan (270 days of delinquency on monthly payments), the government can garnish your wages and your credit will take a major hit.
Either way, paying off your debts will help improve your debt-to-income ratio. This makes you more likely to be approved for a mortgage in coming years, so that you and your girlfriend can think about buying a new house.
However, I would caution against using all of your savings to achieve a debt-free life. While it’s important to pay off your student loans, you want to make sure you still have an emergency fund.
I hope this helps you figure out your next steps and gets you on the path to financial freedom. A well-paying job is a great find in this economy, and for those of you out there (especially recent grads) who need help landing that job, check out our job search tips.
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