Help a Reader: 401k or Debt

Here's a question I received from a reader recently. I think it's a pretty easy decision, but maybe I'm missing something:

I am starting a new job with a nice raise.  I am debating what to do with the additional money.

The new job has a very generous 401(k) match - 75% of the first 8% contributed.  However, my wife and I are aggressively paying down some substantial debt - primarily a $10,000 car loan at 5.9% interest and a personal loan of $10,000 at 8.9% interest.   We also have over $40,000 in student loans that we would like to pay off ahead of schedule.

The problem is this, if I contribute 8% of my salary to the 401(k) in order to get the match I will not be able to pay extra towards the debt.  Should I use my raise to fund my 401(k) to get the company match, or use it to pay off debt?

So, what would you advise him to do?

FYI, we discussed this issue last Friday if you want to see what people had to say on the comparison of debt versus a 401k.

Comments

[Chris Eaker]

Debt first.

[Undertrader]

I'm assuming you're young since you have student loans, so if I was in your shoes, I'd pay off the debt first, which will give you way more income on a monthly basis going forward and then I'd do the 401k matching. You're young enough that if you got completely out of debt and could pocket your entire income every month, you'd be a gazillionaire by the time you retire, but leaving yourself at risk due to debt isn't worth it. IF, you were to get laid off, a pay cut, injured, company went out of business and you found yourself with all that debt still, you'd be in a world of trouble and have to go deeper in debt to get out. Pay off the debt, be debt free and then invest every extra penny you have and you will be set for life.

[Lauren]

If you ask me, he is leaving a 6% raise on the table if he tackles debt, too. You have to look at the future value of that money. Chances are, it will grow more than even that 8.9% loan. The 75% match alone beats that. You may take longer, but in the end you're be wealthier.

[Steve]

Contribute to the 401(k). Why leave free money on the table? And by retirement that money will probably much more than the debt is today.

Seems like a simple choice - a 75% return -vs- a max 8.9% return. Sure the 75% return is not guaranteed (the stock market can go down) but still.... I say go with the 401k.

[Devin]

Are we really debating whether to get a maximum 8.9% return compared to a guaranteed 75% return?

You never get the early years of 401k investing back. Money invested into the plan in these early years of employment can be tens of thousands of dollars upon retirement, especially considering a GUARANTEED 75% up front return on your money.

Absolute no brainer.

[LotharBot]

You get an instant 75% return on anything put into the 401k and then probably 8.9%/year or better from there on out, and pay 8.9% per year on the stuff that's not in the 401k. Phrased another way, you immediately LOSE almost 43% (75/175) of the value of money you don't put into the 401k.

The only reason to pay down the debts so quickly that you can't fully fund your 401k is to give yourself more flexibility in the near future, since you don't have immediate access to your 401k (though many companies will allow you to take out a no-interest loan from your 401k for certain purposes.)

I would prioritize heavily toward funding the 401k, and then toward paying down the highest-interest debt second. Stay current on all of your debt, but don't worry too much about getting ahead until you've picked up all that free money.

(Caveat: before you do any of it, make sure you have a short term emergency fund. The 75% instant return on your 401k is worthless if you end up losing a similar amount taking out payday loans.)

[beastlike]

I'm all for having no debt, but I'm with Lauren on this one!

[DebtyBetty]

I too have substantial debt, including about $17,000 in student loans and an additional $15,000 or so in "bad debt," including credit cards and a prosper loan. However, I still contribute the minimum to my 401k to get the company match. Although I was hesitant at first, I've learned this is a good thing for a couple of reasons.

A) Because I can't afford to save more than $100 or $200 a month on my own, my 401k contributions have made the biggest addition to my net worth, since it is the only asset of mine that continually grows. So while my debt payoff and additional savings is slow-going, my 401k contributions give my assets and overall net worth a nice increase every month.

B) I'm making an instant 50% return on my money, in addition to whatever market returns.

C) It really doesn't make that much of a difference in my net paycheck because of the tax benefits. Plus, I don't have to think about it, and it's a savings that I can't touch. I also feel very responsible looking forward to my retirement and future, even though I'm only 26.

So I'd say definitely contribute, but just the minimum, to your 401k.

[Brandon Barkley]

401k for reasons stated above.

[Edmund]

It also depends a lot of how much this guy is making.

Student loan's interest is tax deductible, as long as your income is below a certain level. (It phases out) If by contributing to your 401k with pre-tax dollars, you may furter pushes your taxable income down (well actually, it's the AGI that matters). This may mean an extra tax break, on top of the match that you will be getting.

[Hal]

401(k) first. Lots of people have already said why--a guaranteed 75% return versus 5.9%? Plus, the interest on the student loans is usually less than the stated rate because of tax preferences.

401(k) all the way.

[diymoney]

Max out the match, then pay off debt.

Each dollar you put in to the 401k up to the match gives you 75 cents back, a 75% return.

Don't put money beyond the match. Instead, put money into the 8.9% loan. Paying off the debt gives you a guaranteed 8.9% return, which is (probably) better than the expected short-term market return.

[tatsrus]

Seems like a no-brainer. 75% return instantly and guaranteed on anything up to 8%. Plus this money compounds tax-deferred until retirement. Meanwhile you're only paying out just under 9% for a personal loan. Forget trying to pay off the student loan too fast. That loan is subsidized at a lower interest rate - no hurry there. The car loan should go after the personal loan since that asset depreciates and chances are, by the time you pay it off, it will not be worth much. So in order:

1. Contribute up to 8% to 401k.
2. Pay off personal loan (b/c of the higher rate)
3. Pay off car loan (b/c it depreciates)
4. Pay off student loan

This is assuming you've already saved up an emergency fund.

[FMF]

FWIW, I'm in the 401k camp too.

[Richard]

Undertrader: With most student loans you can defer the payments because of things like loss of job.

401(k) all the way.

I'd rather have some debt and a secured retirement than be debt free with little/no retirement savings. Get over the 'have to be debt free' mentality, do what makes sense.

[diymoney]

Looking more closely at the comments, I realize I should argue my strategy further:

Getting the match is a no-brainer. It's a 75% return.

Paying off high-interest debt like credit cards, before investing in the market, is also a no-brainer. Hanging on to low-interest debt is OK.

The question is, what counts as "high-interest" debt? To fully appreciate the value of paying off debt, you should compare the interest rate on the debt against the AFTER-TAX returns on an investment.

Paying down the debt gives you the equivalent of a *guaranteed* 8.9% *after-tax* return. This is like getting a guaranteed 11% return in the market! What a sweet deal!

An investment in the market gives an *expected* 10% *pre-tax* return, which is only about 8% after-tax, depending on your tax situation. So you should draw the high-interest cut-off at about 8%. But that's only an "expected" probabilistic number. So I'd lower the cut-off to 6%. Anyway, no one expects the market to return 10% in the next year.

The question is complicated a little further by the fact that the 401(k) is tax-advantaged. But you don't actually avoid paying taxes on the 401(k), you just defer the taxes. So the analysis above still holds.

[diymoney]

Last comment I swear: I'm with tatsrus:

1. Contribute up to 8% to 401k.
2. Pay off personal loan (b/c of the higher rate)
3. Pay off car loan (b/c it depreciates)
4. Pay off student loan

[Kimberly]

So before this great raise happened, was he okay with not paying extra toward the debt? How have they been "aggressively paying down some substantial debt" if all of the raise from the new job can go toward the 401k or the debt but not both? I say as long as the 401k matching is 100% immediately vested, I would put the 8% in the 401k. I would also find other ways to cut expenses to start putting any extra money, no matter how small of an amount, toward the debt.

[Anitra]

Since you sound really serious about paying off your debt, I'd concentrate on that, and put a minimal amount towards the 401(k). I'd still put SOMETHING towards 401(k), though - maybe 1-2%.

I am also serious about paying down debt - student loans and a house in my case. I just started a new job at a company that offers a full match up to 4% of my salary. Once I am eligible, I will contribute about 1% - since it's before taxes, it will hardly make a dent on my take-home pay. Once more of our debt is paid off, I will ramp up my retirement savings.

Keep in mind - the company match is only "free money" if you stay with the company long enough for it to vest. Personally, that hasn't happened with any of the jobs I've had before.

[Edwin]

I understand the situation with aggressively paying off debt as my wife and I are in the same boat.

Like many have said here the match is a no-brainer in my opinion. A 75% guaranteed return just can't be beat from what I've seen. I think about it this way, I can make 8.9% by paying off the debt or I can make 75% by having the company match my contribution. The choice is easy, take the 75%. Do check things like vesting period if any of that applies to you and how long you think you'll be at the job, but otherwise you should be good to go up to the 8% they'll match. Remember, your contributions to the 401k are pre-tax so it'll actually get taken out of your gross pay before it's taxed which is another big advantage. I really beleive in paying yourself first before any creditors especially in this case.

The next thing would be the next highest interest which is the 8.9%. Put whatever is left over to that one until you pay it off and just pay the minimum on the rest. It will take longer but if you look at your returns like 75% - 8.9% you're still making your money work and getting you a return of 66.1% which means you're still building wealth even though paying the debt is slower. Debt isn't always bad in that case as long as you're working on reducing it. Another way to think about it is, if you could, would you borrow money at 8.9% to be able to invest it and get 75%? Sure! You'd end up with a 66.1% return using the bank's money. :)

[Saver]

I'm going to have to go debt on this one. The math has already been done for the advantage of the 401k, but I would prefer to payoff debt and invest 100's if not 1000's more dollars into my future than the bare minimum. Then again, that's just me.

[Kevin]

If you're already truly "aggressively paying off the debt" then you should be in good shape there. Take the guaranteed 75% match on the 401(k) and don't look back.

Pay off the personal loan first (8.9%), car loan second (5.9%)and lastly the student loan (probably under 5.9%, and interest is deductible above the line for tax purposes).

[carol]

Take advantage of your employer's 8% match--hands down. Take it from someone who is older, and has been in the same place that you are, you'll never make up that money. The earlier you start to save for retirement the more freedom that you have later on. You'll pay up your debt ok--just bite that bullet and pay yourself first! You need to start saving a little at a time over your entire working life. Believe me, if you start now, you won't be sorry later.

[Jim]

I go with the majority on the 401k advice. At the same time, this person needs to find ways of cutting expenses that will also pay down debt. All of have something that we can cut. Also, this person should consider a part-time job to help eliminate some portion of debt and then let the debt snowball take effect.

[BradM]

Pay minimums on:
car loan
private loan
student loans
If money is left over, contribute to the 401K where you are comfortable.
If any is left over...pay down debt, starting with the private loan.

[Tim]

The 75% return is nice but keep in mind that this is a one-time return. Your loans have interest rates that will compound annually. So this isn't quite the no-brainer that everyone makes it out to be. To get the best answer, I think you'll need to estimate how long it will take to pay off your debt and do the math.

Tim

[diymoney]

There's a related discussion here (which One Frugal Girl coincidentally points out today) which introduces some subtle considerations:

http://money.cnn.com/2007/12/11/pf/right_call.moneymag/index.htm?section=magazines_moneymag

The 401(k) match is a one-time reward, whereas the loan interest is a continual interest loss. If you're more than 6 years away from paying off the loan, then your extra loan payment today will return you 75% during this time. So the extra loan payment is better if your loan payoff date is more than 6 years away without making extra payments.

I suppose the best strategy is this:
1. Make sure you pay off the personal loan at 8.9% within 6 or 7 years. This means a payment of about $170 per month towards this high-interest loan.
2. Max out the 401(k) match.
3. Make extra payments to the personal loan.
4. Car loan.
5. Student loan.

Priorities (1) and (2) basically mean your maxing out your money to earn a 75% return over 5 years. Nice job!

[LotharBot]

The previous 2 comments miss something:

The 401k match is an instant return of 75% into an interest-bearing account. Over 6-7 years, the 8.9% interest will come up to 75% if you don't pay off that loan AT ALL -- but your initial investment plus the 75% will end up growing substantially more, even in a down market. Compound interest is in play both places. To cancel out the instant 75% match, you need a HUGE difference in returns over the long term. Unless your 401k plan completely blows, there's no way the 8.9% loan is more important over a time period of less than 20 years.

1) contribute to 401k up to max match
2) pay down 8.9% debt
3) pay down 5.9% debt
4 or 5) contribute to 401k above and beyond matching
5 or 4) pay off student loans

If you'll be at the company long enough to actually get your 401k match, the first 3 steps are a no-brainer. The only real debate is over steps 4-5 -- is the rate you get in the 401k (unmatched) enough better than the rate on subsidized student loans to make up for the benefits of being debt-free?

[Tim]

LotharBot,
How is a 401(k) going to grow in a down market?

I think there are too many unknowns in this scenario to give a perfect answer. If he contributes 8% to his 401(k) all we know is that he won't be able to pay extra towards debt. This is really too vague since we don't know what he is really able to pay down in the first place. We also don't know if he is fully vested with the 75% immediately or does he need to work there for a certain # of years. The 75% might not be a guarantee.

All I suggest is that it really insn't a no brainer. It all really depends on how long he will be carrying the debt and the other factors I mention.

Tim

[SusanB]

When I was a new graduate, 28 years ago, one of my first goals was to save a down payment to buy a house. I didn't plan to invest in the company savings plan when I became eligible after 6 months of employment.

A coworker pointed out that the company matched 2/3 of the first 6% that I contributed to the savings plan and encouraged me to invest something. Looking back, it may be the most important advice I ever received.

I started out at 2% the first year and increased the percentage at raise time every year. With a decade, I was contributing the maximum 16%.

I'm all for paying off debt and living debt-free. But it is also very important to start long term savings early.

I'm currently 51 years old and have been retired for 2 years.

[Becky]

I'm definitely with the 401(k) fans. Start now or you'll always end up with some expense that keeps you from getting around to it.

[kitty]

Everyone seems to put student loans at the botoom, but there is no information here about the student loan. Is it a subsidized loan with low fixed interest or is it a private loan with high interest that can be raised further at any time? What is the interest on the student loan?

Additional issue is job security and how much money they have. 401K is great, and it would be a pity to loose such a great match, but if one of them looses a job, will they still be able to pay for loans?

[diymoney]

Lotharbot is right. But I think he still agrees that this reader needs to pay something towards his loan. Exactly how much he should pay depends on some big assumptions about how much he will earn in his 401(k). As Tim rightly suggests, it's worth doing a little calculation to figure out exactly how much.

Here is the math as I see it:

Every dollar in the loan costs you (1 + h)^T, where h is the high interest rate 8.9% and T is the total loan lifetime.

Every dollar in the 401(k) returns you 1.75 * (1 + r)^T over the same time period T, with a given return r.

You can use this to solve for T assuming various values of r. This tells you how long it takes for the loan interest to catch up to the 401(k) contribution + match + earnings. You shouldn't leave any dollars in there for longer than T, so the loan should be paid off in exactly T years.

If the 401(k) earns more than 8.9%, r >= h, then the loan never catches up to the 401(k) match and you should milk that loan for as long as possible.

With a somewhat conservative r = 6, you get T = 20 years, and payments of $90/mo. If you leave your money in the crappiest interest-bearing account available, r = 2, you still find T = 8 years and payments of $145/mo.

Anyway, we have no idea what this person will invest in. r = 5, T = 15 and payments of $100/mo sounds like nice, round, conservative numbers.

1. Pay $100/mo towards the 8.9% loan
2. Max the 401(k) match
3. Car loan
4/5 Student loan, max out the rest of the 401(k) (lotharbot is certainly right about this too. i personally would lean towards prioritizing the 401(k) over the student loan)

[diymoney]

my final priority list should have read:

1. Pay $100/mo towards the 8.9% loan
2. Max the 401(k) match
3. Pay down the 8.9% loan
4. Car loan
5/6 Student loan, max out the rest of the 401(k)

[Foobarista]

As for the down market, that is exactly the time one should be shoveling $$ into the 401K. Buy low, sell high, and all that...

[FMF]

One factor to consider: raises.

We're making assumptions here that he stays at a steady income for several years (which won't happen, he'll get raises.) To me, that makes the 401k even better since the ONLY way paying off the debt works better is that if it takes years (maybe a decade or more) for him to do it and the 401k doesn't vest for several years. But if he applies raises to the debt, he can start the 401k now and pay extra on the debt as early as next year (with his raise.)

BTW, he can also use bonuses, gifts, etc. to pay off the debt early.

[Debbie]

For me, this is a no-brainer. Put 8% into the 401k. You are guaranteed an instant 75% return on your money.

[bubba]

I think it's premature and a little misleading to say definitively that taking the 401k match is the "obvious" thing to do.

You have to look at your overall financial picture, rather than focusing on squeaking out an extra .33333333% "return" here and there.

Say you have $20,000 in debt at 8.9%. And you pay the minimum every month for 8 years. When it's paid off you'll have spent over $8000 in interest alone. That's money going directly to the cloud!

Pay off the debt. Stop hemorrhaging money. Use interest for you rather than letting it work against you. Without the debt albatross around your neck, you'll have so many investment opportunities that before you know it your net worth will skyrocket past where it would have been had you continued to pay the minimum just to get those precious few percentage points.