If you read enough different Personal Finance blogs, you find that there are a number of popular recurring themes. Ways to save on various purchases, how to plan for retirement, etc. The one that’s been haunting me lately is, as the title today says, saving vs paying off debt. There are some obvious choices to be made, such as paying down an 18% credit card or putting that money in the bank to earn .01% interest. (Uh, if it wasn’t obvious, pay the damned card!)
But, then there’s the grey area where the debate really has no conclusion, no right or wrong, just what’s right for you. First, a disclaimer. In the PF blogging community, it’s ok to disagree. Disagreeing isn’t a personal attack in this case, it’s just a different take on an issue. That said, It was two months ago that I read Are 401(k) and 529 Plans a Good Idea When You’re In Debt? I was part of the 78 comments that quickly went up after Joan Otto (Man Vs. Debt community manager) wrote this article in which she described how she’d prefer to go at her debt 100%, even to the point of sharing that she was sorry she or hubby even had their 401(k)s to begin with. She explained that they had a combined $44,000 in their retirement accounts averaging 8% return, but $59,000 in debt costing 14%. Ouch. I understand that’s an issue. The real issue that Joan shared was that their 401(k)s had no match. Game over. Really. Joan’s plan to pay off her debt with a vengeance was exactly the right thing to do.
What drew me in to the discussion was where Joan remarked that even if there were a match, she’d pass on it, and take The David‘s advice. If your employer is going to match the first few percent of your income dollar for dollar, my opinion is to take this free money. The match is usually up to the first 4-6% of income, which should leave enough funds so the debt repayment plan doesn’t suffer too much. Joan mentioned paying $2500 per month (wow!) toward the principal on her debt. That’s $30,000 per year. I don’t know their income, but even if we are looking at $100,000, I’d suggest steering the $6000 toward the match if there were one to be had. But that’s all hypothetical. Let’s move on to a real situation.
My ‘friend’ (ok, it’s a close relative. Let’s stick with friend for this delightful anecdote) mentioned that she’d qualify for a refinance of her mortgage once her credit cards were paid off. $10,000 at 18%, so the $400/month she was paying toward the cards would take nearly 32 months to pay off. She told me that she stopped depositing to her 401(k) and I thought about Joan’s story. My friend’s company had a match, 4%. This was $3000 left on the table. I looked at the numbers, and made an offer. I wrote her a check to pay off the cards, and she’d putting in $250/mo to the 401(k). Since it comes off the top, it’s $188 less in her take home pay. This leaves $212 to pay toward the $10,000. At the end of 32 months, she’ll still owe me $3,680, but her 401(k) will have $16,000 that wasn’t there before. Yes, the $16,000 is pretax, but she’s over 55, so if she changed jobs she can take it out with no penalty, just tax. At 25%, she’d still clear $12,000. I’m not forecasting any gain, in fact, she’s probably wise to keep this money in the short term bond fund for now, to know that it’s safe. And the refinance – once the cards show as paid on her credit report, the refi should save her another $200 per month.
There’s something admirable about killing the debt, I get that. I get that debt feels like a weight you just want to get rid of. But after nearly 30 years of matched 401(k) deposits, I see the power of compound growth on top of matching deposits. I see that I could have taken $200K over the years and paid off my mortgage by now, or I can have that $200K in debt and far more than twice that sitting in a retirement account. It’s tough to stay the course, especially when you look at how the S&P has crashed twice in the last 15 years. For most 401(k) accounts, I’d say to deposit to the match and that’s it, but walking away from that free money is a mistake, in my opinion. Keep in mind, most 401(k)s offer a low risk investment choice. Even though I might not choose it myself, it’s a good alternative to using the excuse of a ‘risky market’ to avoid saving altogether.
How have you handled the debt decision? Are you passing up a match in your retirement account?
Joe,
I’m still in my 20s and I have no debt. My parents paid for my tuition, so I’m most fortunate (I still worked throughout college because I covered my living expenses). But I also started contributing to my 401(k) that does have a match!
I suppose if I was in major consumer debt, I’d consider reducing my retirement contributions.
-Christian L. @ Smart Military Money
My debt payoff plan was doing both. I knew I had to pay myself (401K) to feel accomplishment as much as getting satisfied by paying off my credit card bills.
While I didn’t make the most of my money by paying off debt and saving much more than the match, I liked watch the bars in Quicken all move in concert. I *felt* I was getting more done.
And that emotion of feeling a retirement build was inspiration to carry me through with living a more austere lifestyle and concentrate on my debt. I felt I *deserved* to be debt free, because my retirement account showed that I can save money.
Sometimes the decision to become debt free needs to be emotional, not calculated. I automated the saving, but I made a habit and an emotional reward to pay off debt.
I think it depends on what the debt is and how overwhelming it is. If it was a high interest loan, pay it off fast. If it was a house loan and the payment is easy to make, keep it.
One strategy could also be done outside of the 401K (which you don’t have control over how they invest it). Save, save, save in order to invest.
When you get a tidy profit that has been growing in the bank, consider buying another piece of real estate that can give you positive monthly cash flow with rental income.
Once you have some positive cash flow, you can either use the funds to add to your monthly payment for your debts.
It is true that employer matched contributions to the 401K plan is free money and should be taken advantage of. However, if you are able to get great returns by investing on your own, then do so. This can be the base of your future wealth building. It will have less rules and restrictions, and you will be the one in control.
That’s great! And thanks for writing. It’s hard to argue with a decent match, and I’ll maintain that all but the most desperate of people should grab the match, and then attack the debt.