Help a Reader: Stop 401k Contributions to Pay Off School Loans?

Here's a question I recently received from a reader:

My wife and I both work and contribute the maximum to our 401k accounts. We are good savers, don't use credit, etc. However, we do have a large student loan from my wife's medical school education that we are paying the minimum on. The loan balance is currently ~$45K with 8.25% interest.

We would really like to accelerate the paydown of this loan and are considering stopping contributions into one of our 401k accounts for a period of 2 years and applying the money to the loan, in addition to increasing our regular monthly payment.

Mathematically, I know those 2 years of contributions will be worth a lot in 30 years when we retire, but psychologically, it would be great to be free from this debt and the $2-3K of interest it generates each year.

I told him what I recommended, but now it's your turn. What would you suggest this couple do?

Comments

[Todd]

Pay off the loans as fast as you can.

[GeckoGirl]

I'm in a similar situation and I choose to max out the 401(k). I get to enjoy the tax benefit as well as bulking up my retirement account. I do try to send extra money to the student loan though.

[Moneymonk]

Consolidate the loans first to get a lower interest rate. Do not stop 401 contributions, contribute at least 6% to get a match from there just pay extra towards the principle on the loans. Bonuses and tax refunds apply that also to the student loan debt as well. He may want to take an extra part time job to attack the debt as well to become aggressive

[Geo]

Assuming you could earn an average 10% rate of return over the next 25 years, forgoing $30,000 to pay down an 8.25% loan would cost you potentially $325,000 in future 401(k) growth. Of course, this assumes you would yield a return in excess of your loan rate and 10% is achievable given past market performance. Of course, you will have saved $6,000 in interest paid on the loan. Try to find other sources to pay down the student loan (bonuses, taxable savings) to address the pyschotherapy issues. Given the tax deferred nature of the 401(k), it's tough to justify the student loan payoff with those funds.

[MEG]

This couple should do both! They should contribute at least enough to their 401k's to get any company match. Then they should use the rest of their available money to accelerate payments on that loan.

Alternatively, one or both of them could get a part time job and put all earnings towards the loan repayment. That way they can keep up their full 401k contribution AND accelerate the loan repayment. It doesn't sound like this is totally necessary, but it's a goo way to go if you have the time/energy.

[Jeff]

If the stock market continues to decline over the next year, you could benefit by temporarily decreasing 401k contibutions and paying off debt faster. Make sure you start buying back into the stock market just before it starts going up again (which is easy if you are psychic).

[justin]

Actually, you want to buy as much as you can while the market is low.

However, you will want to not forgo any company match, so lower the 401(k) contributions until you have what you want to pay on the loans, but make sure you get any and all match

[kitty]

It depends on a number of factors, one of which would be how much they have left after expenses every month, how secure is their job, etc.

Assuming they more than enough money left every month to get the employer's match and still have some left over, I'd say put enough in 401K to get employer match - this is often at least 50 cents for each dollar, sometimes dollar for dollar, so this is a huge gain. Then pay the loans. But if the job is not secure or if they don't have any money left after contributing to 401K and paying the bills, I'd say pay the loans first.

I think 10% is optimistic, but even if it's not, it'll be a while before you can have access to this money. But.. if one of them looses a job, they still have to come up with payments on the loans.

Trying to get a smaller percentage makes sense, but if they get one of those 0% for a year deals, they need to pay it off within a year or they'll pay more.

[EMF]

Does contributing the maximum to your 401(k) mean?
(A) to the maximum that the employer will match,
or
(B) to the IRS limit of $15,500 (in 2007).

If (A), don't change. If (B) drop back to (A) and put the difference against your debt. Or put the difference into a Roth IRA first and then toward your debt. Assuming you have your emergency fund built up.

And since we're talking 2 401(k) funds, consider them individually and then together. Would make no sense to contribute to one fund at $15,500 and give up employer match in the other.

[mysticaltyger]

I say keep contributing to the 401Ks to the fullest. It's not only that they have the potential to make 10% in the stock market...but also the fact that they are contributing to the 401Ks PRE TAX!! So for every $100 they contribute to the 401K, they're probably only paying $70 out of pocket (maybe even less) because of the pre tax nature of 401ks. If they put less in the 401ks they're paying with AFTER TAX money. I agree with GEO....they need to find other sources of income such as part time jobs(or spend less if possible to accelerate student loan payments) to deal with.
their "psychotherapy" issues.

Another possibility is to borrow from credit cards with 0% deals (or low "life of the balance" deals, as American Express seems to have a lot of these) and pay down the student loans faster.

[Dough Roller]

We need some more info to answer the question:

1. What is the employer match, if any?

2. Can the loans be consolidated to lower the interest rate?

3. Are they able to deduct the interest from their taxes?

All of that said, I'd be inclined to continue with 401k contributions. It's a good habit even if a spreadsheet says you can "save" a percent or two paying down the debt. As for possible declines in the stock market over the next few years, as one comment mentioned, such a decline would make it a perfect time to amp up 401k contributions. Of course, none of us knows what Mr. Market will do today, let alone over the next two years.

[plonkee]

At 8.25% I'd suggest paying off the loans. Its sufficiently close to the expected stock market average over 10 years that there is a reasonable chance it would be better mathematically, and its sounds like it would be better psychologically.

[cory]

You guys made an investment in your education, and your paying the purchase price now, it's obviously going to be a good investment if you can afford to even consider maxing out your 401ks.

So keep paying into your 401ks. If you're maxing them out, you're obviously pulling in enough cash to take care of your bills and then some. After all, you're not going to be sitting in retirement thinking, "I'm so glad we paid off those student loans in 2 years."

If you really just cannot bear to keep making those full student loan payments, drop both of your 401k contributions back a bit and put that extra money towards the loan, or wait until your next raise and put that toward the loan. Or trade babies on the black market and use the profit to pay off the loan--get one with good genes and you can wipe out 45k in 1 kid.

[JB]

Everyone - thanks so much for the helpful comments and thanks FMF for posting my question. This is a great resource with generous and smart people.

Dough Roller - one of our employer's has a very good match (8%, I think). The other has the typical 4%. The loan cannot be consolidated to a lower rate (believe me, I've tried) - the type of loan restricts this. We are not able to deduct the loan interest as our income is above the limit for that deduction.

Thanks.

[Anitra]

Do not completely cut off contributions to your 401(k), but reduce them and put the extra money towards your loans. The 401(k) is more valuable in the long run, but you'll need to make loan payments no matter what happens in your life - job loss, medical emergency, etc. So work on getting that loan paid off while also saving up for the future.

My husband and I are in a similar situation, though with only one 401(k) (his job doesn't offer one). We contribute the max for employer matching, and put the rest of our "spare" money towards our loans. We want to be able to live on one salary once we have children.

[Adam]

Keep maxing out the 401k. Like what has been said above, since the 401k is pretax you will get the average growth (usually about 10% depending on your risk tollerance) on the full $15,500 you and your wife each put to the 401ks each year. Back one of them off you will only net maybe $10k in take home pay (assuming 28% Fed tax bracket) to put towards the student loans.

So, over two years you can either increase one of your 401ks by $31,000 while gaining the average 10%....or decrease your student loan principle by $20,000 saving you 8.25%.

Moral of the story, don't forget about the after tax effect of not contributing to the 401k. You really will not be able to put the full $15,500 to those loans each year.

[Adam]

Keep maxing out the 401k. Like what has been said above, since the 401k is pretax you will get the average growth (usually about 10% depending on your risk tollerance) on the full $15,500 you and your wife each put to the 401ks each year. Back one of them off you will only net maybe $10k in take home pay (assuming 28% Fed tax bracket) to put towards the student loans.

So, over two years you can either increase one of your 401ks by $31,000 while gaining the average 10%....or decrease your student loan principle by $20,000 saving you 8.25%.

Moral of the story, don't forget about the after tax effect of not contributing to the 401k. You really will not be able to put the full $15,500 to those loans each year.

[Ted]

Get all your match on the 401k. Plow the rest on the debt.

[Brad]

I guess this is another example of why they call it personal finance - lots of different answers, based on different personal situations and histories. You have to choose what's right for you, even if we knew your situation better (do you rent or own or want to upgrade houses, have or want kids, job stability, etc.).

That being said, I would recommend a solution in the middle - reduce 401K contributions (maybe keep contributing 10k each for the theoretical better returns) and accelerate the loan repayment (11k - taxes + current payments + any extra for the guaranteed 8.5% return). This probably takes 4 years instead of 2.

[GD]

I have a similar problem. I have a student loan paying 13% apr, I am contributing to 401k up to 6% of salary.
My employer matches 100%, should I reduce contributions to 3%? and pay off loan faster?

[FMF]

GD --

If it were me, I'd put in enough to get the full match, then either try to pay off the debt or refinance it at a lower rate. If I could get it at a lower rate, I'd fully fund the 401k, cut my spending, and pay off the loan as soon as I could.