401k versus Debt -- Which to Pay First?

It's very rare for me to read an article and agree totally with its advice. I think that's because there are so many things left up to judgment calls in personal finance that agreeing with someone 100% is almost impossible. Plus, many of the articles I read are focused more on trying to be sensational (and get readers) than offering practical advice.

But every so often, I run into a nugget and say "I totally agree with that!" Such was the case the other day when I read an article from Money's Ask the Expert column about whether to put money in a 401k or pay down debt first. Here's the question:

I'm 25 years old, have about $30,000 in my 401(k) and carry a $3,500 balance on my credit cards. I'm thinking about stopping my 401(k) contributions to pay off my credit-card debt. What do you think?

I love the response. The author pulls no punches:

I've got a better idea: How about you continue contributing to your 401(k) and at the same time make a concerted effort to get rid of that credit card balance as quickly as possible at the same time?

Clearly that means you'll have to shift some of your income from spending to debt repayment. With a $3,500 balance, your minimum payment is probably about $88 a month now. If you continue just paying the minimum (which will decline as your balance does), it could take you 23 years to erase your balance -- that's right, 23 years.

But if you pay $150 each and every month, you can get rid of that debt in just under two and a half years. Pay $250 a month and you'll eliminate the balance in less than a year and a half.

Yes, I know that making those extra payments may be painful. But in this case, pain is good. It will help you to remember how much more difficult it is to repay debt than it is to pile it on. That's an important lesson to learn at any time. But if you can pick it up early in life, it's especially valuable since you'll be less likely to inflict damage to your finances later on through reckless borrowing.

Talk about tough love! Then the author goes on to say why cutting your 401k is a bad idea:

Of course, you could...halt your 401(k) contributions and use that money to repay your debt. But, assuming you do that, what have you really accomplished? True, you've gotten rid of your debt. But you've also given short shrift to your retirement.

In effect, you've created a situation where the downside to racking up debt -- a smaller retirement nest egg -- is pushed off way into the future. Because the penalty is so remote and indirect, it's less likely to affect your future borrowing habits, which is to say, you might find yourself facing the same situation again.

Once this explanation is given, the author goes back to the tough love approach:

So my advice is that you continue making your 401(k) contributions and then do whatever you have to do to knock that credit-card balance down. If that means eating out less often, or buying fewer neat electronic gadgets, or cutting back to basic cable, taking less lavish vacations or even skipping vacations altogether for a while, so be it.

In the end, I think this approach will be worthwhile because your retirement nest egg will continue to grow and you'll know from first-hand experience just how difficult it is to get out of debt once you've sunk into it. And unless you're some sort of glutton for deprivation, once you've learned that lesson you should be less likely to let your credit-card balance get out of control again.

At a minimum, this person should contribute enough to his 401k to get the full company match before paying down his debt.  And if he's like most Americans, he'll have plenty of discretionary expenses available for cutting -- so he should have that debt paid off in no time.

Comments

[geoff]

What I want to know is what profession this guy is in?!? I'm terribly impressed that he is only 25 and has 30k in his 401(k).

Maybe he lives at home.

At least I *hope* he lives at home. At least that gives me *some* excuse for not even being remotely close to this guy's retirement and being older than him. ;-)

[Fed guy]

I belive this is right. I'm only 23 and have 10,000 dollars in my retirement. By 25 I should have about 30K. Working for the Federal Government pays. In regards to the 25 year old guy. I also have the same problem. I have about 8,000 dollars debt and was thinking to stop my retirment contributions and pay my debt. Is a tough decesion.

[Another 25 year old]

$30,000--three years out of college working in a high demand field making 50k+ is definitely attainable if you have a good 401k and you keep expenses low. I'm 25 and I saved 10k in about ten months. But I didnt get out of school until 23 and didnt start saving until 24. Stupid mistake.

[Ken]

Agreed. I have debt and am still contributing aggressively to my 401K (all while drastically kicking back my lifestyle). First off, I'd like to say that I'm 25 too and I've been contributing to my 401K for about 2 years now and have about 36K saved (32K in my 401K and 4.2K in a Roth IRA). I now contribute 21% of my pretax to my 401K and get an additional 4% from my employer. But that wasn't always the case, at first I was contributing only enough to get my match but one life-altering incident made me change my ways. I went on a long business trip and as part of the agreement was told the company would pay for my return flight back home every month. I took them on the offer and flew back 2 months into my trip but little did I know, I am responsible to pay taxes on the plane ticket my employer purchased for me to fly home. At that point, I decided to increase my contribution to "make up" the money that uncle sam took away such that my net taxable income for that year would remain the same. It took a bit getting use to the pay deduction at first but now I don't miss the money. I think I was young enough to not have gotten use to making that much that I was able to make such a drastic switch without feeling much pain. Now the motivation that drives me to keep this level of contribution is the rationale that if I save aggressively now, I can start kicking back my contribution gradually as I age. Also I've started learning about "proper" investment allocations. So I moved all my money from safe bonds and money market accounts to very aggressive 100% stocks, with much higher return.

Now all this time, I went from being a financial retard to someone very financially knowledgable. I learned about loans and how to calculate APRs to determine what I was "really" paying. This lead me to increase my monthly payment on one of my two student loans (I have two - one that was $5K at 7% APR, and another that is $18K at a consolidated 2.75% Constant APR). I continued to make minimum monthly payments to my low APR loan and aggressively paid off my higher interst loan. Now I'm just left with the smaller loan and am in no hurry to pay that off (as 2.75 is typically smaller than inflation).

Of course, to make any of this possible I think twice before throwing money away - limited my time going out to clubs, bars, buying useless gadgets, haven't taken a vacation in a while, et cetera... In hindsight, I would have never thought I could have turned a negative into such a positive. Now that I have decreased my debt and am in full control of my retirement future, I feel I have greatly benefited. Two years of pain reducing debt and contributing to a 401K can be a life changing event.