Last week I asked the following question:
Let’s assume an individual has $10,000 in credit card debt at 14.99% interest and their employer matches 401(k) contributions dollar-for-dollar up to 6% of gross pay. Should this person:
* pay off his or her credit cards first before investing in the 401(k)
* invest at least 6% in the 401(k) immediately to take advantage of the employer contribution
* or take some other approach?
This question comes up in a lot of different ways:
- Do you pay down your mortgage or invest?
- Which debts do you pay first?
- Do you wait to invest until all your non-mortgage debt is paid?
These are important questions, and some answer them with unbending, dogmatic, “I’m right, you’re wrong” types of answers. I don’t think there is only one right answer and suggest you consider three things in making the right decision for you:
- The Numbers: The starting point is to look at the hard, cold numbers. Which approach will yield the most return. In the Question of the Week, this factor clearly favors investing in the 401(k) because of the employer match. Without the match, this factor is less clear, and would involve comparing the tax advantages of a 401(k) with the 14.99% interest rate.
- Cashflow: Does one option improve or hurt how much cash is available to you? This often comes up in deciding which debt to pay first. For example, by paying down a home equity line of credit, you have the available credit still available to you in case of an emergency. The same is not true when you pay down a car loan. Also, it may be worth paying off a low balance, low interest debt to increase your monthly cash flow. This is the Dave Ramsey Debt Snowball approach. While this is a factor to consider, unlike Ramsey, I don’t think it is always the deciding factor. In the Question of the Week, this factor again favors investing in the 401(k). If you an emergency, you can always borrow from or withdraw from your 401(k). Yes, there is a 10% penalty if your under 591/2 and you pay taxes, but we’re talking about true emergencies.
- You: It is important to know yourself. Can you pay down debt, never borrow again, and then begin investing? This, too, is the Dave Ramsey approach. The problem is that many pay down the debt, and then borrow more, creating a never-ending cycle of pay debt–borrow–pay debt–borrow, and never saving. If that’s you, don’t wait to pay off all your debt before saving. For our Question of the Week, only you can assess this factor.
So what’s the answer? For me, I would definitely invest in the 401(k) first. What would you do?
Published or updated February 14, 2013.