When deciding whether to pay off a loan or credit card first, it’s usually best to choose the one with the higher APR. The higher a debt’s APR, the faster interest accumulates, and the more expensive it will be to pay off. For example, if there’s a 15% APR on the credit card and a 25% APR on a personal loan, it’s much wiser to focus on paying off the personal loan first, and vice versa.
However, if your loan is backed by collateral, such as a secured personal loan or a home equity loan, that might change your decision. Paying off that loan first will mean that you’ll no longer have a risk of losing the collateral, which is especially important if the loan is secured by your house. But if you’re talking about unsecured debt, the APR should take precedence in your decision.
Why It’s Usually Best to Pay off a Credit Card First
Credit cards tend to have high APRs – the average for new offers is about 19%, and the average for existing accounts is roughly 15%. Compare that to personal loans, where the average is closer to 10%, according to data from the Federal Reserve. So in many cases, paying off a credit card first will be the better idea.
Credit card interest compounds daily, too. That means every day you owe interest on both the principal balance and the interest you’ve already accumulated. In contrast, personal loans can have compound or simple interest. With simple interest, the more common method, you only owe interest on the principal balance. And personal loans with compound interest can compound less frequently than credit cards, such as monthly or annually. This is just another reason why credit cards tend to be more expensive.
Consider Paying Off Both at the Same Time
That said, you don’t necessarily have to choose between paying off a loan or a credit card first. You could get a personal loan to pay off those two debts at the same time and consolidate them together into one large balance with one monthly payment. This is worth looking into only if you’re able to get a personal loan whose APR is lower than the current APR on both your credit card and loan debts.
Just watch out for any origination fees that might take away from the savings you get with a lower APR. You’ll also need to make sure you qualify for a loan with a high enough dollar amount to pay off the existing debts.
Alternative Consolidation Option: Balance Transfer
Another option is to consolidate by moving both debts to a balance transfer credit card. These cards give an introductory APR of 0% for a certain number of months, up to 18-21 months in some cases. But after the 0% period expires, you’ll owe interest at the card’s regular APR, which is usually high.
So balance transfer cards are best for debts you can pay in full by the end of the intro period. Consolidation loans are better for debts you want to pay off over a longer period of time at a consistently low APR.
Finally, don’t forget that if you keep your debts separate rather than consolidating, you can’t make payments on just one balance and ignore the other(s). Both credit cards and loans require minimum monthly payments. You must pay the minimum on both each month, or risk credit score damage. But anything you contribute above your required minimum payments should go to the debt with the highest APR.