When paying off your debt, there are only a few scenarios in which it is better to pay off a low-interest loan before a high-interest loan. Most of the time, it is a good idea to pay off your high-interest loans before your low-interest loans due to the amount of money you save in interest payments. Which loans you pay off first depend on the amount of the loan and the loan's terms and conditions.
Understanding Interest Payments
The interest you pay on a loan is compound interest. This means the lender applies the interest rate on your loan to the principal balance as well as the accumulated interest.
Loans have compounding periods in which they calculate the interest charge and add it to your balance. Typical compounding periods for loans are monthly or daily. For monthly compounding periods, the lender calculates your interest payment based on the average monthly balance of your loan. For daily compounding periods, the lender calculates your interest payment based on the average daily balance of your loan. To save money on compound interest charges, pay off high-interest loans first.
A pre-payment penalty is a fee, usually a percentage of the total loan amount, that the lender charges you for paying off your loan early. Lenders put pre-payment penalty provisions or clauses in loan contracts to compensate them for the interest payments they will lose when you pay off a loan early. If you have a large pre-payment penalty attached to your high-interest loan, you may want to consider paying off your low-interest loans first.
If the balance on the low-interest loan is equal to or higher than your high-interest loan, pay off the high-interest loan first to save money on interest payments. If your low-interest loan has a low balance, consider paying that loan off first. Then, take the amount of money you were putting toward the low-interest loan you just paid off and apply it to your high-interest loan. Doing so will help you pay off your high-interest loan faster.
The amount of credit you have outstanding, meaning the amount of money you owe to your creditors, can affect around 30 percent of your Fair Isaac Corporation (FICO) credit score. Paying down the outstanding balances on your loans, whether they have high interest or low interest, helps increase your credit score and improves your overall credit. Additionally, paying off your loans indicates to lenders that you are responsible for the credit that is currently available to you and present a low risk of defaulting on future debt obligations.