Should I Pay Off My Car Loan or Credit Cards First?

I had a reader write in to tell me he was going to use his economic stimulous tax rebate check to pay down some of his debt. As a married father of four, he is expecting to receive a fairly sizeable rebate.

"I am so close to paying off my car loan, but I have some debt on my credit cards, too," he wrote. "I was fortunate to get a fairly low interest rate on my credit cards, so I'm torn between trying to pay off my car loan or pay down my credit card debt."

Your Credit Mama recommends paying down your credit card debt first, for a couple of reasons.

1. First, we all know how capricious credit card lenders are. Just look at Bank of America's recent move to increase interest rates on credit cardholders for no apparent reason. Because so many credit card agreements contain clauses such as any time-any reason rate changes and universal default (where a drop in credit score - even if inaccurate and/or unrelated to the account - will trigger a rate increase), carrying balances on credit cards is becoming a dangerous gamble.

2. Paying off credit cards improves your score more than paying off the other loans. The FICO scoring algorithm places a higher importance on your credit card balances. Your score will increase as your debt ratio on your credit cards decreases, while your score may not increase much at all by paying off your car loan, or student loan, or other type of installment loan.

Your goal should be to get your credit card balances to less than 30 percent of your total credit limits. So if you have a $1,000 credit limit, you should charge no more than $300. If you have several credit cards with balances, rather than paying off one card entirely, you may want to pay enough toward each card in order to get all of the balances down to 30 percent or less.