Our commenter Datacloud asks,
Given the state of the economy today, is it better for me to reduce my 401k to a minimum and use the extra funds to pay off my credit card debt? This is a good time to put money into the markets, based on my admittedly limited understanding, but with interest rates going through the roof (my personal Chase card went from 12.99 to 23.99), I would like to kick down my cc debt (now at around $6,000) faster. I’m currently only putting 6% in my 401k, and I’m fairly young (35). Have you advice for me?
Does your employer do any sort of matching? If so, keep at least enough of your salary directed to your 401k to earn that free investment money. Beyond that, however, we think it comes down largely to whether or not you’re disciplined enough to see this strategy through to the the end as quickly as possible; it’s probably not going to be worth it if you end up amassing revolving debt again.
If you can stick to the plan, and then re-route everything you were paying on the Chase card into your 401k as soon as you pay off the card, it could work out in your favor. We say this after running some sample numbers through Bankrate’s calculators. We got the idea from former financial planner Gary Foreman at stretcher.com, who suggests using these Bankrate tools to estimate your net worth after n years.
Here’s what we did. To keep it simple, we assumed no raises over the next 4 years, as well as no employer matching contribution, and we started the 401k balance at $0. Instead of true net worth, we’re only looking at the total net worth of the 401k after 4 years after you subtract the cost of paying off the credit card.
Annual Salary: $40,000
Currently paying 6% into 401k, or $2400/yr, $200/mo
Debt: $6,000 @ 23.99% APR
Let’s say your current Chase payment is $200/mo. At that rate, it would take 47 months to pay off, and cost a total of $9,400.
Let’s say you cut your 401k contribution in half from 6% to 3% of the 40k salary—in other words down to $100 a month. You added the other $100 to the $200 you were already paying Chase. Under this new $300/mo payment, it would take 26 months to pay off, and cost a total of $7,800.
Now let’s look at how much your 401k would be worth under both scenarios, assuming an annual rate of return of 8%.
If you leave things as they are and contribute 6% a month over four years, your 401k would be worth $11,278.
However, if you dropped your contribution to 3% for two years, but then bumped it up to 12% for the remaining two years, it would be worth $13,448. We say bump it to 12% because we’re imagining that after you paid off the Chase card, you’d have that extra $300 a month that you could re-allocate to your 401k, meaning you could put $400 a month total into it for the remaining two years of this plan.
Scenario 1 (leave things as is):
Value of 401k after four years: $11,278
Total cost of Chase debt: $9,400
Total net worth: $1878
Scenario 2 (temporarily reallocate funds):
Value of 401k after four years: $13,448
Total cost of Chase debt: $7,800
Total net worth: $5648
We fudged a lot on this estimate. For example, we rounded up by 1 month on the first scenario and down by 2 months on the second in order to use the Bankrate tools, which slightly exaggerates the difference between the two final numbers. We also didn’t take taxes into account, since you’ll be paying more if you reduce the amount going into your 401k, and that should slightly work in favor of Scenario 2.
But even going by such rough estimates, you can see that the second scenario is better—IF you can follow a couple of rules to the letter:
- As soon as you pay off the debt, reallocate that monthly payment to your 401k to make up for the lean times.
- Don’t rack up any more revolving debt.
Having said all this, you should really run the real numbers and try to be more precise if you want a more certain answer. Or go see a financial planner.