When it comes to finance there are few issues that are black and white, right or wrong. This makes it tough for anyone answering a question but unable to draw out the further details needed to give the topic an in depth review. Often it comes down to numbers vs feelings. It gets even tougher when a reader writes “but the numbers show that those who feel good about their results…..”
That said, today I’d like to offer my take on the “pay off debt or invest” debate. When the choice is between paying off high interest debt or saving, even in an IRA, I agree, pay the debt. As we slide toward paying off that 6% student loan or 5% mortgage, the discussion gets more gray. Not to make this a Dave (Ramsey) post, but I’ve heard him as well as many financial bloggers suggest to pass on even a matched 401(k) until the debt is paid off. Not so fast, let’s do some math, I promise to keep it pretty short and simple. You work for an employer who matches the first 5% you put in, dollar for dollar. You are in the 25% bracket. To put $2000 in the 401(k) costs you $1500. Your employer matches it, and you have $4000 in the account. In 12 months, the $1500 you didn’t pay off is now up to $1800. You now borrow out half that $4000 at 6% interest pay off the $1800 and an extra $200. I understand the warnings against borrowing 401(k) money, and for the most part, agree. In this case however, if you lose your job, you have $2700 (after 25% tax and 10% penalty). Sure, you owe the 401(k) loan $2000, but you still pocket an extra $700 and knocked off $1700 in credit card debt. Grabbing that money is a low risk proposition.
We are told by the motivational guys to plan for success, not failure, right? You are going to stay employed. Your employer keeps matching your deposits. After 5 years, you have $20,000 deposited (I’ll ignore growth for now) which only cost you $7500 out of pocket, and you have $10,000 in a low interest 401(k) loan instead of high interest credit card debt. A 15% difference in interest is enough to keep funding the account and help you continue hacking away at the debt. I’m sure it’s a great feeling to pay off that last credit card bill, no doubt. Imagine how much better you’d feel also having a nice balance growing in your retirement account, funded with a combination of the employer’s money and the interest you saved by shifting from the cards to the lower interest 401(k) loan. It may take some month longer, depending on the amounts owed, their rates, and what you are able to pay toward the debt, but keep your eye on the big picture, the sum of the 401(k) balance minus the debt owed. This method will see your net balance rise fastest.
Of course, this takes discipline. You first need to get your spending under control and be committed to putting as much toward your debt as possible. Don’t confuse this idea with the suggestion that you take a loan from your 401(k) separate from the deposit and match. The steps I describe are the way to avoid missing the match which is free money, and at no point do you owe more than the match you are grabbing.
Disclaimer – If you really believe you’ll feel better paying off three 6-8% credit cards with $1,000 balances instead of applying that $3,000 to the 24% card with a $10,000 balance, then this advice may not be for you. And that’s ok, I hope my other posts give you ideas you can better apply to your finances.
Joe