Paying off credit card debt vs. funding your 401(k)
By Jeremy M. Simon | Published: January 9, 2007
When we are presented with two options that both seem good, it can be tough to make a decision. This is true in the case of the choice between using extra money to pay off credit card debt or to invest in a 401(k) retirement program -- both of which are recommended by financial advisers.
In an ideal situation, it would be possible to both pay off credit card debt and contribute the maximum amount to an employer's 401(k) retirement fund. But for most of us, we have to make the most of a limited amount of money. So for Americans faced with the decision between paying off credit card debt and funding their 401(k) plan, how should we best put our money to work?
First, consider your credit card debt. The average interest rate on credit card accounts is about 15 percent. That is very costly, especially since credit card interest payments are not tax-deductible. So with most credit cards charging 15 percent interest on whatever balance is owed, paying off credit card debt is equal to earning a guaranteed 15 percent return on your money.
Next, consider your 401(k) plan. Many employers will contribute 50 cents for every dollar you put into the plan, for a guaranteed 50 percent return on your investment. Additionally, the money you invest in your 401(k) plan grows tax-free until you take it out. That is a major difference from the money used on a credit card, which gets no special tax treatment.
Based on this logic, it looks like the 401(k), with its tax-advantaged 50 percent return, trumps paying off your credit card debt and its regular "return" of 15 percent. However, when you consider that a 50 percent employer match on your 401(k) investment is a one-time deal, while 15 percent interest on a credit card balance in ongoing, it becomes clear that you should first pay off the credit card debt.
But in order for the math to work in your favor, after paying off the credit card debt, you have to make sure not to run up a balance again in the future. Additionally, once you have erased your credit card debt, you should contribute the full amount to your 401(k).
It is almost always a good idea to avoid carrying a credit card balance. But what if you feel you should begin contributing to your 401(k) immediately, and therefore have to revolve a credit card balance to do so? Could this be a better option for you than paying down your entire credit card balance first?
To do the math, imagine you have $150 each month in extra money as well as a $4,000 credit card balance racking up 15 percent interest. In this case, the minimum credit card payment each month would be about $90.
If you choose to first get rid of your credit card debt, by using the full $150 each month to pay down your balance, you could eliminate the credit card debt in 32 months at a cost of $756 in total interest. After your credit card balance had been reduced to zero, you could then invest the entire $150 into your 401(k) each month. With an employer match of 50 percent and an annual 8 percent return, your 401(k) would reach $5,410 in 54 months -- the same time frame we will consider below.
However, if you decide to begin contributing immediately to your 401(k), putting $100 a month toward paying off your credit card debt and the other $50 into your retirement plan, it will take those 54 months to eliminate your credit card debt at a cost of $1,341 in interest. With the employer match and an 8 percent annual return, you would have $4,890.
By first paying off your credit card debt, it would be erased almost two years sooner than by trying to use money for both the debt and the 401(k) simultaneously. Meanwhile, your 401(k) would grow by an additional $500 over the 54 months. Therefore, paying off your credit card debt first, then investing fully in your 401(k), wins out.
Of course, since a credit card bill is paid with after-tax dollars while a 401(k) is funded with pretax dollars, a truly real-world comparison must include the impact from taxes.
As an example, if you are in the 25 percent federal tax bracket, you need to earn $200 to net $150 after taxes to pay off your credit card debt. But if you decide to tackle the debt while also investing in the 401(k) as outlined above, you need to earn just $183 for the $100 after taxes and the $50 pretax. The difference could then be also invested in your retirement account.
Using this approach of both paying down the credit card debt and investing in the 401(k), you would have $6,508 at the end of the multitasking period. But if you first paid off your credit card debt, you would then have more to contribute to a 401(k), which would in turn yield $7,188.
Therefore, when given the option, it makes financial sense to first tackle your credit card debt completely before then moving on to contribute the maximum amount to your 401(k) plan. One way to quickly reduce credit card interest payments (which can save you both time and money) is to apply for a balance transfer credit card with a lower APR than the credit card you are currently using. Lower interest rates mean smaller credit card bills, which in turn mean less time paying off a credit card balance and an earlier start contributing to a 401(k).
In closing, to truly make the most of your money, employ good financial behavior. Always pay off your credit card balance, and be sure to take advantage of a 401(k) plan that offers an employer match.
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