How to Handle Six Money Dilemmas, Credit Card Versus 401k

Money magazine lists six money dilemmas and what to do about them. Over the next few days, I'll list each dilemma, what Money suggests as the best option, my take on the issue, and additional FMF posts on the topic. Here goes:

Dilemma #1: Pay off a credit card OR fund your 401(k)

Money's suggestion: If you have a big credit-card balance, wipe it out before you open a 401(k).

My take: This is a very hard one -- probably the hardest of the group.

I never really had to face this situation since I've always paid off my credit cards in full. So my suggestion would be to never buy anything on a credit card that you can't pay off right away. If you live by that principle, you'll never have to face this issue.

But if I was in the situation where I did have credit card debt, I'd first look to cut my expenses so I could do both (pay off the cards and at least get my 401k match). If I couldn't do both, I'd look at the interest on the credit card and how much I owed on it. If it was above 15% or so and if it was a big balance, I'd pay it off first. If it was below 15% and not such a big balance, I'd go with the 401k first (but still would sell some things, take gifts, etc. and pay off the debt asap).

FMF posts related to this topic: Help a Reader: 401k or Debt, 401k Match Trumps Debt Repayment

What's your take on the issue?

Comments

[Bryan]

I think it depends on how long it will take you to pay off your CC debt. If it's going to take you 5+ years, you are really missing out on the compounding which can be really, really hard to make up for.

[Mike W]

So I am in this situation (sort of).

I suggest doing what I am doing:

Pay down the CC with some extra savings (still working towards that emergency fund)

Look at your witholding!!! Use that W4 calculator from the IRS (and then be paranoid like me and assume "worse case" for the incomes - actually best case.. make more than expecting). I estimate that I will receive a 4,000 return this year. That is going to CCs.

In 2008 I plan on witholding a lot more than the "1" I do now (single earner making decent money in Database work Married with 1 child, 1 on the way in March, God willing).

With that, I should be able to give 6% to my 401(k) (which is the maximum my company will match) and still get an extra 20/30 each check (more for the CC).

Once the CCs are done, I am going to work to build up a bigger emergency fund (single earner with a family...) then put extra on the car that has the lowest amount.. The move it all to the next car..

So..

Do Both..

1.) If you save, rob from savings to pay debt (if you have a bit of a cushion for emergencies.. some say $1,000 some more..)

2.) Change witholdings and take the extra that resutls (and in the calculator plan on putting in your 401 so you realize that tax savings also) and apply it to the 401 (you'll never know you missed it and as long as you still have some to pay your CCs faster than minimum)

3.) Try to aim first for at least the maximum employer match. It's free money.

Disclaimer: If your CC debt is so high that you need to get that controlled first or you will be with it for years than maybe hold off on the 401. But I suspect that with a budget, a plan and a will you can do both.

This year my income has not changed significantly but because we are forcing ourselves to I have been able to begin tithing a "full" 10%, fund my 401(k) and take control of our debt. The tithin has helped it all and because of the refund (because of the tithing deduction) I will be CC free by March hopefully.

[Dan D]

Funny this should come up, I acted upon a similar situation I'm facing today. I have just under $2k in credit card debt. I'm unwilling to stop funding my 401k as well as my IRA. Or, for that matter, to stop saving for an engagement ring. Fortunately I have good credit and have attractive options. I played my cards off one another and was able to find a balance transfer offer that charges 0% thru October. Unless something unforeseen happens and my emergency fund can't handle it, I should knock it out by then. Net cost - 3% of the balance transfer.

Of course, if you have a significant amount of CC debt this won't work. There's also a decent chance your credit won't provide the ability to get a 0% BT offer.

[Kevin]

I faced this situation a few years ago after a divorce. I was trying to get my financial house in order and re-assess where I was headed. I determined it was better psychologically to pay off that debt in full before funding any additional 401(k), except the minimum to get the full company match of course.

It worked out well for me since the following spring I paid off my car early and got a kick start to saving for a new house. I have been pretty allergic to debt ever since.

[Honest Dollar]

There is a mathematical "crossover" point where it becomes better to get the 401(k) match. Besides all the normal assumptions about returns, length to retirement, future savings, etc., this point primarily depends on how high your debt is, the interest rate on that debt, the structure of your 401(k) match, and, most importantly, how much money you have to apply towards either debt or retirement.

If you have only a little money that can go towards either debt or retirement, and your debt balance is high with a high interest rate, it's better to use that money to pay off debt.

If you have enough money to completely pay off your debt in 3-6 years (these numbers depend on your situation), then it's actually better to pay just the minimum and start funding your 401(k) (but going back to debt paydown after you've contributed JUST enough to get the match, no more).

The crossover occurs because on one end, your debt is accumulating too fast and hurts your final net worth. On the other end, delaying contributions to your 401(k) not only means you won't get an instant return (from the match) but also that your savings has fewer years to compound.

Unfortunately, the math to find each person's "crossover" point isn't horribly fun or easy. Still, this is a decision worth serious thought for those who find themselves facing it.

[Lord]

If you have credit card debt with a high rate of interest and more substantial than can be paid off in the next several months, don't fool yourself into thinking you are being financially responsible by contributing to a retirement plan. Admit you have a problem and seek help. Until you face it, you will likely just continue as is and get no where.

[Mayor of Greenlake]

Here's a mathematical example: You're making $50K/year and have a $6,000 credit card at 15% interest. You want to decide whether to contribute 6% of your salary to your 401K that has a 50% match, or put that money toward paying off the credit card. The 6% rate is $3,000 per year... employer match is $1,500... assuming a 7% rate of return over half the year (because you didn't have it all in there on Jan 1), you earn $158 on that money. At the end of the year, you have $4,658 in your 401K, and it only REALLY cost you $2,250 because you're in the 25% tax bracket so saved ~$750 in taxes on that $3000. Meanwhile, you've made minimum payments on the credit card and have paid nearly $900 in interest... BUT overall, your 401K gain was $2,408 ($4,650 - $2,250) so even after deducting the $900 in interest, you're $1,508 ahead of where you would have been if you'd put all that money into the credit card.

[Honest Dollar]

Mayor, I don't think that's the right way to think about the issue. Getting the match comes out ahead for the year in your example, but since debt and 401(k) balances compound over time, the real question is whether a person is better off at retirement.

Quick detour: The person in your example would not just pay interest in his debt. The minimum payment is usually 2% - 4% of the balance per month. If we take the minimum payment to be 2%, then in one year he'd pay closer to $1,400, of which $900 would be interest.

Back to the main issue: If you assume retirement comes in 15 years or more, the person in your example is actually worse off by getting the match before he pays off debt. Let's assume he has $4,440 each year to either pay off debt or put into his 401(k).

If he pays the minimum on his debt, gets the company match, then goes back to pay down his debt more:
- At the end of Year 1, his debt balance is $5,300. His 401(k) balance is $4,700. His simplified "net worth" is -$600.
- At the end of Year 10, his debt balance is $1,900. His 401(k) balance is $71,100. His simplified "net worth" is $69,200.
- At the end of Year 20, his debt balance is $600. His 401(k) balance is $220,500. His simplified "net worth" is $219,900.

If instead he puts all $4,400 towards debt until it's paid off, then goes back to fund his 401(k):
- At the end of Year 1, his debt balance is $2,100. His 401(k) balance is $0. His simplified "net worth" is -$2,100. (So Match First is better strategy in this single year.)
- At the end of Year 10, his debt balance is $0. His 401(k) balance is $69,000. His simplified "net worth" is $69,000. (This is only $200 lower than if he had gotten the Match First all along.)
- At the end of Year 20, his debt balance is $0. His 401(k) balance is $220,600. (This is $700 more than he would have had he put Match First.)

Now, even if retirement were really far away for this person, the truth is that it doesn't make much of a difference (as a percentage of his final net worth) whether he puts debt first or the match first. This is because his debt is small relative to how much he can contribute and his interest rate is low relative to the national average (19.8% according to what Mint.com tells me).

If, instead, we look at someone making the average national income, $48,000; has the average rate of 19.8%; really got into trouble with credit cards and carries a balance of $10,000; and only has $4,000 per year to either pay down debt or put into a 401(k)? If this person is 20 years from retirement, trying to get the match before paying off debt completely would cost her $17,000 in final net worth. She'd still have $2,600 in debt when she retires!

My conclusion: For most people (since most people don't carry $10,000 balances and can contribute more than $4,000 a year to either debt or retirement), getting the match makes sense. But it's dangerous to generalize that since for a person with that credit card balance, at that rate, with that kind of match, for ONE YEAR only, getting the match makes sense, then it must make sense for everybody.

Remember, the people that are really torn between debt or match are exactly the ones most likely to fall under the small set of conditions where paying off debt actually makes sense: they have a lot of debt at high rates and not a lot of money to put towards debt or retirement.

(By the way, I used to be a proponent of Match First, No Matter What, until I actually made an Excel model to see what would happen.)

[Teaspoon]

Good Post, was one of my favorites for carnival or personal finance.

I agree the direction that you should be trying to do both if you can. I'd even go so far as to say, it doean't matter what your credit card debt is, you should always fund your 401k to max the match (since in many cases this is 25%, 50% or more return automtaically, plus the annual return of the underlying investment options).

I'd say: max your 401k match. Make sure that you have solved your credit issues (i.e. you need to solve your problems of overspending and using credit, otherwise it doesn't matter what you do becuase your bad credit habits are going to swallow you up no matter what). Going beyond the max of 401k match, you should start BTs and or HELOC transfers out of the higher rate credit card balances. Then work on paying off the low interest HELOC and 0% credit cards next with your choice of snowball effect.

If you have ESPP avail that produces 40% or more annually in discounts, I'd fund it fully from your HELOC and take that guaranteed 40% return, etc. and use it to pay off your outstanding debt. This has been a recent revelation for me to utilize HELOC to fund your ESPP and take that free money off the table, while still alllowing you to max your 401k matches, etc.

Teaspoon