In my last post I described Adam and Ben and how much money they’ve missed out on by not investing in their company’s 401(k). But what I didn’t address was whether or not they had any debt obligations. Today we will discuss how to decide between paying off debt and investing for the future.
When I first thought about writing this article, I was going to tell you to contribute to your 401(k) up to your employer’s match regardless of debt. Then, I thought about how the match is a one time occurence, but interest rates are compounding for the entire life of your debt or investment. So, if you have a lot of high interest debt, like a credit card, you will probably want to pay that off in full before diverting any money to a retirement account. To verify this, I came up with some examples.
Let’s compare paying debts off early to paying the minimums while contributing to your 401(k). For each of these examples, let’s say that the person has $500 each month to split between debt payoff and their 401(k), and that their contributions will grow at 7% per year. Note: These calculations are approximate and ignore any tax benefits that may be present.
100% Employer Match
Let’s say the person’s employer will match 100% of their 401(k) contribution up to $200 per month and compare 2 different debt scenarios.
Student Loans
If the person has $30,000 in student loans at 6.8%, they will need to pay $279.65 per month for 20 years to payoff this debt. By contributing $220.35 to their 401(k) each month, and receiving the $200 match, they are left with exactly $279.65 to pay the minimum on their loans. After 20 years, this strategy will net them $245,356.46. However, if they chose to put all $500 towards their loans, they could pay off the debt in just over 6 years and use the remaining 14 to make $500 contributions into their retirement account. While paying off the debt much quicker, this strategy would only net $195,138.34.
Credit Card Debt
In the above example, the interest rate of the student loans was less than the return of the investment account, so it makes sense that investing as early as possible would be better. Let’s look at an example with a much higher interest rate. Let’s say instead of student loans, this person has $8,000 in credit card debt at an 18% APR. The minimum payment for this card the first month is $200, so they commit to investing $300 each month and putting the remaining $200 towards the credit card. This will take them 62 months to payoff the debt and yield $37,218.21 in their 401(k). Putting all $500 toward the credit card debt, it can be paid off in 19 months leaving 43 months to invest in the 401(k) and yielding $34,099.16. Even though the interest rate on this debt is much higher than the 7% return in the investment account, the 100% match is enough to outweigh the difference.
50% Employer Match
Let’s see how the same scenarios shake out at a 50% match. For these two examples, the employer will match only 50% of the first $200 contributed each month.
Student Loans
Simultaneous Investment = $193,263.79
Early Payoff = $167,261.43
Credit Card Debt
Simultaneous Investment = $29,774.57
Early Payoff = $29,998.35
As you can see, at a 50% match, the high interest rate of the credit card overpowers the returns you get from investing early and the person was able to save slightly more by paying the debt off early. For a more drastic difference, let’s take a look at these scenarios with no employer match.
No Employer Match
For those of you who don’t have jobs that offer a 401(k) retirement plan, you can get the same 7% return by investing the money yourself. Let’s take a look at the math for these two examples when there is no employer match.
Student Loans
Simultaneous Investment = $141,171.12
Early Payoff = $139,384.53
Credit Card Debt
Simultaneous Investment = $22,330.93
Early Payoff = $24,998.62
While the math shows that in some cases you want to payoff the debt as soon as possible and in others you only want to pay the minimums, that is not the only factor you should take into account. If you have a stable job with a very low probabilty of being let go (teacher, nurse, police officer), you can take on more risk and hold a higher debt balance than someone with less steady income (actor, telemarketer, model). I encourage you to calculate different investment/payoff strategies for your own debts and choose the one that best fits your risk profile while giving you the most money to retire on.
Which strategy are you using to save for retirement? Did you calculate the future value of your account before deciding? Let us know in the comments below.