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Should a person with high credit card debt pay it off before contributing to a 401(k) with matching?

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Can you take out a loan against your 401(k)? Get the best of both worlds: low interest rates to pay off your debt, and an employer match on your contributions. (But be smart. Make sure you can keep paying it off just as fast as before.) –  fennec Nov 16 '11 at 20:47
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+1 to fennec. I like this solution. Most people think that a loan from a 401k is a terrible idea.. but if you're getting 100% back on that 401k money.. that will outweigh any disadvantage you get from a loan. Someone who knows more about this should make it into an answer. –  user606723 Nov 16 '11 at 21:01
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I would like to hear a break down of the loan from 401(k) as well. I am one of those "don't take a loan" but that is a gut reaction from years of other gut reactions. –  MrChrister Nov 16 '11 at 21:27
    
For the purposes of this question, lets say, yes, 50 percent of the total assets under the plan can be loaned out. –  jldugger Nov 16 '11 at 21:35
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There are two main risks of the 401(k) loan: 1) You lose your job. Now, you have no income, and you need to pay back the loan within 60 days. 2) You potentially pay yourself less interest than the return you would have received from the investments the money otherwise would have been in. –  Randy Coulman Nov 17 '11 at 12:47
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8 Answers 8

A matching pension scheme is like free money. No wait, it actually IS free money. You are literally earning 100% interest rate on that money the instant you pay it in to the account. That money would have to sit in your credit card account for at least five years to earn that kind of return; five years in which the pension money would have earned an additional return over and above the 100%. Mathematically there is no contest that contributing to a matching pension scheme is one of the best investment there is. You should always do it. Well, almost always.

When should you not do it?

  1. When your non-discretionary spending is so high that putting money into the pension plan would put you deeper in debt. Frankly that is almost never true. If you think you are in this position, cut your spending more, and do both: make the matching contribution and pay off the debt. If it really is true, and you no longer spend anything on cable TV, meals out, or entertainment, then you should be paying off the debt.
  2. Your pension fund is already so full that you don't want to put more into it. This is another thing that technically might be true but in practice almost never is. Even if you are only a couple of years away from retirement, you could put the money into the 401K, pull it out in a couple of years and pay off the credit card debt then, and still come out ahead. Wouldn't you really rather have that incredibly awesome vacation when you retire, instead of the pretty awesome one you have planned now?
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"Your pension fund is already so full that you don't want to put more into it." - Is that possible? To have this yet carrying a debt on credit cards? Seems a contradiction. I actually can't imagine "so full" as it was my intent to observe "full enough," then work another year or two, to "a bit more than full" and call it quits. –  JoeTaxpayer Nov 17 '11 at 3:20
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As I said: "technically might be true but in practice almost never is". –  DJClayworth Nov 18 '11 at 17:04
    
"You are literally earning 100% interest rate on that money the instant you pay it in to the account." - most 401(k)s I've seen have a vesting period, meaning that they match it on the books, but it doesn't actually become yours for a few years. –  Stephen Cleary Nov 21 '11 at 21:13
    
If your funds (not just the matching funds) were locked in for so many years that you would incur 100% interest on the credit card debt in that time, AND there was no possibility of paying off the credit card debt any other way in those years, that might be another case when you might choose to pay off the debt. Not very likely I feel. –  DJClayworth Feb 9 '12 at 1:33
    
There are maximum contributions to 401k schemes in the United States. –  Affable Geek Nov 6 '12 at 21:15
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Nope, take the match. I cannot see not taking the match unless you don't have enough money to cover the bills.

Every situation is different of course, and if the option is to missing minimum payments or other bills in order to get the match, make your payments. But in all other circumstances, take the match.

My reasoning is, it is hard enough to earn money so take every chance you can. If you save for retirement in the process, all the better.

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And now I am waiting for @JoeTaxpayer to bring the math and prove me wrong. –  MrChrister Nov 16 '11 at 16:27
    
I'm going to go with this too, because impulse buyers will just run up the credit card debt again, once they realize "hey I've got this whole credit line that I won't have to worry about for several years" –  CQM Nov 16 '11 at 16:58
    
Let's play some math. At a punitive interest rate of 25%, continuously compounded (a close approximation to the daily compounding you probably have), it will take you about 2.7 years for your debt to double (ln(2)/0.25). (At a more down-to-earth "expensive" credit card rate of 15%, it'll be about 4.5 years.) If your employer match is 50% instead of 100%, you'd be looking at 1.6 and 2.7 years. (ln(1.5)/0.25 and ln(1.5)/0.15). How many years your contribution set you back from paying off the debt? Is it fewer years than that? If so, the match is the better deal. –  fennec Nov 16 '11 at 21:01
    
Ha! I just +1 you as you are right on. I'll compose a longer analysis later, but it will support yours, just with some numbers. –  JoeTaxpayer Nov 16 '11 at 23:40
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For easy math, say you are in the 25% tax bracket. A thousand deposited dollars is $750 out of your pocket, but $2000 after the match.

Now, you say you want to take the $750 and pay down the card. If you wait a year (at 20%) you'll owe $900, but have access to borrow a full $1000, at a low rate, 4% or so. The payment is less than $19/mo for 5 years.

So long as one is comfortable juggling their debt a bit, the impact of a fully matched 401(k) cannot be beat. Keep in mind, this is a different story than those who just say "don't take a 401(k) loan." Here, it's the loan that offers you the chance to fund the account. If you are let go, and withdraw the money, even at the 25% rate, you net $1500 less the $200 penalty, or $1300 compared to the $750 you are out of pocket. If you don't want to take the loan, you're still ahead so long as you are able to pay the cards over a reasonable time. I'll admit, a 20% card paid over 10+ years can still trash a 100% return. This is why I add the 401(k) loan to the mix.

The question for you - jldugger - is how tight is the budget? And how much is the match? Is it dollar for dollar on first X%?

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Hope this isn't against etiquette, but this is more of a hypothetical question. I'm really looking for a platonic ideal argument against the "never ever carry credit card debt" line, and this seems like a great one. My budget right now allocates about 35k to building up net worth, but friends and family ask for advice sometimes and I want to confirm my intuition here. –  jldugger Nov 17 '11 at 17:05
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It's fine. At one end of the spectrum is that no debt group, at the other, those who are irresponsible. The no-debt guys have a religious zeal about it that ignores the numbers completely. They will tell you to prepay your 4% mortgage before you put a dollar towards your matched 401(k) in the most extreme case. If they sleep better at night, that's great. I have different priorities such as that match comes before everything, then the high interest debt, etc. I think we are on the same page. –  JoeTaxpayer Nov 17 '11 at 18:12
    
jldugger, in either case, it's a good question and will provoke me to ask any friends with <s>credit card</s> debt whether they're contributing to their 401k. –  user606723 Nov 17 '11 at 19:13
    
user606723 - at least to the match if any. For unmatched deposits, I'd pay the cards off. –  JoeTaxpayer Nov 17 '11 at 19:25
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Agree with Randy, if debt and debt reduction was all about math, nobody would be in debt. It is an emotional game.

If you've taken care of the reasons you're in debt, changed your behaviors, then start focusing on the math of getting it done faster.

Otherwise, if you don't have a handle on the behaviors that got you there, you're just going to get more rope to hang yourself with. I.e., makes sense to take a low-interest home equity loan to pay off high-interest credit card debt, but more likely than not, you'll just re-rack up the debt on the cards because you never fixed the behavior that put you into debt.

Same thing here, if you opt not to contribute to "pay off the cards" without fixing the debt-accumulating behaviors, what you're going to do is stay in debt AND not provide for retirement.

Take the match until you're certain you have your debt accumulation habits in check.

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Mathwise, I absolutely agree with the other answers. No contest, you should keep getting the match. But, just for completeness, I'll give a contrarian opinion that is generally not very popular, but does have some merit.

If you can focus on just one main financial goal at a time, and throw every extra dollar you have at that one focus (i.e., getting out of debt, in your case), you will make better progress than if you're trying to do too many things at once. Also, there something incredibly freeing about being out of debt that has other beneficial impacts on your life.

So, if you can bring a lot of focus to the credit card debt and get it paid off quickly, it may be worth deferring the 401(k) investing long enough to do that, even though it doesn't make as much mathematical sense. (This is essentially what Dave Ramsey teaches, BTW.)

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+1 - I just want to add that if you are that person that has difficulty managing your debt remove the temptation of re-accumulating that credit card debt. Cancel the card, put it in a safe, or saftey deposit box, etc... what ever you need to avoid the impulse to spend money you do not have. –  user4127 Nov 18 '11 at 15:07
    
I agree with this thought process. Mathwise is one thing but getting out of debt (and staying out!) is a huge boost both emotionally and financially. On top of that no more risk (with debt). –  Valien Nov 13 '12 at 22:29
    
Sorry, Randy, The David is right up to a point. Tough to get ahead when paying 18% interest and hoping to get 8-10% on one's 401(k). The monkey wrench here is the match. If one sits down and looks at what they will lose by ignoring the match for a year or two, they might be more incentivized to cut their budget elsewhere. Don't like the loan-juggle advise? Fair enough. But I'd rather see someone pay their debt over 4 years getting the match all that time, than to pay in full in 2.5-3 years and lose the match. The obsession with zero-debt can be costly. –  JoeTaxpayer Nov 28 '13 at 17:49
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I'd take the match, but I wouldn't contribute beyond your match, for two reasons:

  1. The rules on 401(k) accounts can change at any time, and they may then no longer be the rosy deal that they are now. Meanwhile, the money in there gets a fairly large chunk taken out should you need to liquidate it before the prescribed time.
  2. Free money is fine. Great. You've got it. But use any excess that you would have invested to pay down your debt. Unless you have a cherry credit card rate, you'll come out ahead if you pay that down faster.
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I would definitely be putting in enough to get the most out of the match. Only reasons I can think of not too would be:

  1. You are able to pay off the credit card in a very short period of time. In that case, the non-monetary benefits of having it paid off might be worth delaying starting the 401(k) for a month or two.
  2. The match comes with a vesting period and there is a good chance you will leave before the match vests.

Other than that, not investing in the 401(k) is turning down free money.

Edit based on feedback in comments.

The only time I would advocate number 1 is if you are intensely committed to getting out of debt, were on a very tight budget and had eliminated all non-essential spending. In that situation only, I think the mental benefit of having that last debt paid off would be worth more than a few dollars in interest.

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+1 for the caution regarding the vested matching. I'd agree, a bird in the hand... -1 for missing a 100% match for the sake of paying the card a few months faster. And keep in mind, often the match is only on the first 5-6% of one's income. Get that matched, and send every cent you can to high interest card debt. –  JoeTaxpayer Jun 9 at 19:53
    
Ok. +1, I'm not so closed minded as to ignore the mental benefit 100%. Still, we see things differently. I handed my sis-in-law a $10,000 check from my equity line, with the agreement that she'll make minimum payments to my loan and take the rest of the money she was using for payments (on an 18% card) and get her company 100% match. She'll be better off by many thousands of dollars a few years from now. –  JoeTaxpayer Jun 9 at 22:40
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There is a very simple calculation that will answer the question:

Is the expected ROI of the 401K including the match greater than the interest rate of your credit card?


Some assumptions that don't affect the calculation, but do help illustrate the points.

  • You have 30 years until you can pull out the 401K.

  • Your credit card interest rate is 20% compounded annually. The minimum payoffs are being disregarded, because that would legally just force a certain percentage to credit card.

  • You only have $1000. You can either pay off your credit card or invest, but not both. For most people, this isn't the case. Ideally, you would simply forego $1000 worth of spending, AND DO BOTH

Worked Example:

  1. Pay $1000 in Credit Card Debt, at 20% interest.

    After 1 year, if you pay off that debt, you no longer owe $1200. ROI = 20% (Duh!) After 30 years, you no longer owe (and this is pretty amazing) $237,376.31. ROI = 23,638%

    In all cases, the ROI is GUARANTEED.

  2. Invest $1000 in matching 401k, with expected ROI of 5%. 2a. For illustration purposes, let's assume no match

    After 1 year, you have $1050 ($1000 principal, $0 match, 5% interest) - but you can't take it out. ROI = 5%

    After 30 years, you have $4321.94, ROI of 332% - assuming away all risk.

    2b. Then, we'll assume a 50% match.

    After 1 year, you have $1575 ($1000 principle, $500 match, 5% interest) - but you can't take it out. ROI = 57% - but you are stuck for a bit

    After 30 years, you have $6482.91, ROI of 548% - assuming away all risk.

    2c. Finally, a full match After 1 year, you have $2100 ($1000 principle, $1000 match, 5% interest) - but you can't take it out. ROI = 110% - but again, you are stuck.

    After 30 years, you have $8643.89, ROI of 764% - assuming away all risk.

Here's the summary -

The interest rate is really all that matters. Paying off a credit card is a guaranteed investment.

The only reason not to pay off a 20% credit card interest rate is if, after taxes, time, etc..., you could earn more than 20% somewhere else. Note that at 1 year, the matching funds of a 401k, in all cases where the match exceeded 20%, beat the credit card. If you could take that money before you could have paid off the credit card, it would have been a good deal.

The problem with the 401k is that you can't realize that gain until you retire. Credit Card debt, on the other hand, keeps growing until you pay it off.

As such, paying off your credit card debt - assuming its interest rate is greater than the stock market (which trust me, it almost always is) - is the better deal.

Indeed, with the exception of tax advantaged mortgages, there is almost no debt that has an interest rate than is "better" than the market.

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There's a fallacy in your calculations, specific to the compounding 20% over 30 years. While I agree that if one is committed to paying 20% on a credit card balance, even the 100% match gets killed over time. In the OP's case, the card will get paid slower, not ignored completely. And the OP stated he can convert the card debt to a 401(k) loan, currently at about 5%. It would take well over a decade of a 5% rate to negate the 100% match. –  JoeTaxpayer Dec 1 '13 at 21:04
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