Interest paid on auto loans is not tax-deductible unless you have a
business and are using the auto in the business (subject to certain
requirements). Student loan interest is federally tax-deductible up to $2,500,
but phases out when your income reaches certain levels (see these IRS thresholds).
Conventional wisdom would tell you to pay off your auto loan first
since it’s non-deductible. However, it’s not quite as straightforward as whichever category is tax-deductible. Rather, you need to compare the “cost of money”
(interest rates) between the two loans on
an after-tax basis.
Assume, for example, that your auto loan is 4% and your student loan is
7%. Just using federal tax brackets (don’t forget state, if applicable),
here’s how the comparison plays out.
Your real "cost of money" for the student
loan on a federal after-tax basis:
- 15% tax bracket: (1 - 0.15) x 7% = 5.95%.
- 25% tax bracket: (1 - 0.25) x 7% = 5.25%
- 28% tax bracket: (1 - 0.28) x 7% = 5.04%
- 33% tax bracket: (1 - 0.33) x 7% = 4.69%
- 35% tax bracket: (1 - 0.35) x 7% = 4.55%
- 39.6% tax bracket: (1 - 0.396) x 7% = 4.23%
So even if you were in the top federal marginal
tax bracket, it would make more sense for you to first pay off a 7%
(tax-deductible) student loan than a 4% (non-deductible) auto loan.
Hope that helps.
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