What Debt To Pay First?

[lp_fatcat]

I recently received a financial gift of $10K. I currently have two outstanding debts. The first is a credit card with a balance of about $8000 with a 12% interest rate. The other is an outstanding 401K loan of almost $8000 at 8.25% for 60 months. (Loan taken out 12/07 to cover funeral expenses).

Which debt should I pay off first? and why?

[jIM_Ohio]

I would put 8k to the 12% credit card, then 2k to 401k loan.

I would do this because the cc debt at 12% is expensive, and I assume the interest on the 401k loan is lower than 8%.

[maat55]

It depends on how secure your job is. If job is secure, payoff CC. If not, payoff 401. Do you have an EF?

[76Chick]

debt dummy here... but for the 401K loan, aren't you paying yourself the interest anyway??

i say - go for the credit card... it is the higher interest amount.

not sure of your situation - but if you are still employed at the same place, that 401k loan payment comes right out of your paycheck - gone, paid, poof! no envelopes, stamps or worrying.

GL! and congrats on the gift. hope you sent a nice 'thank you' card!

[Finally Frugal]

I'd also pay the CC first, although if you decide on the 401K loan option, then definitely call the CC company and ask for a lower rate. It never hurts to ask, and I've had very good luck with getting rates lowered.

[Aleta]

I would say normally to pay off the credit card loan, but not sure of when and why you took out the 401K loan and the interest rate. I know that the penalty can be 15% before 59 1/2. I think that you have some time to get it paid back in and really this is towards your retirement so you're basically paying yourself back. Are you paying penalties and interest for the 401K loan? I think to get rid of the 401K loan first and to pay $2,000 toward the credit card debt might be wise. It all depends on the penalties.

[Slug]

Originally Posted by jIM_Ohio

I would put 8k to the 12% credit card, then 2k to 401k loan.

I would do this because the cc debt at 12% is expensive, and I assume the interest on the 401k loan is lower than 8%.

This is the correct approach. Most 401k loans have far more reasonable interest rates than CC's.

[disneysteve]

Just another vote for the CC first and the 401K second.

[LuckyJB]

You dont always have to pay off your debt...I mean if your paying to it now consistanlty throw some of that money at it...but I also use that 10K to make money....invest some of it...

[disneysteve]

Originally Posted by LuckyJB

You dont always have to pay off your debt...I mean if your paying to it now consistanlty throw some of that money at it...but I also use that 10K to make money....invest some of it...

Where would you suggest investing the money that would outperform the 12% interest the CC is costing? I sure don't know of anything that would do better than that. I think a guaranteed 12% return is pretty darn good.

[lp_fatcat]

Thanks for the feedback. Just a few more details on my debt...

The 401K was taken out to pay for funeral expenses. The loan was a total of $8000 for 5 years. I took the loan out in December of 2007. I'm currently 32 years old and the payments are coming directly out of my paycheck. My job is pretty stable but who knows what can happen in the future.

The credit card was closed by the company after one late payment so there is no chance of me running up another balance.

I know that you shouldn't borrow money from your 401K so I guess my knee-jerk response was to pay it back first.

[LuckyJB]

oops....I missed the 12% part...do the CC.....and try to avoid digging into your retirement

[lp_fatcat]

yes I have an EF but it's not where it should be

[terry1156]

The reason that staility is important is that if you do lose your job, you will likely be required to pay back the full amount immediately. That needs to be figured into your decision.

[cooliemae]

I know this is going against the grain, but I would pay-off the 401k first and here's why

Assuming modest gains (6% per year) on the 401k over the next 25 years the $8000 would turn into $34000.

Assuming you payoff the 401k loan and can apply $400 per month to the credit card loan you will have paid somewhere in the neighborhood of $1000 in interest over the next 2 years.

So because the life of the 401k is so much longer, I would pay it off first and invest the money at the same time you are paying off the loan.

[Slug]

Originally Posted by cooliemae

I know this is going against the grain, but I would pay-off the 401k first and here's why

Assuming modest gains (6% per year) on the 401k over the next 25 years the $8000 would turn into $34000.

Assuming you payoff the 401k loan and can apply $400 per month to the credit card loan you will have paid somewhere in the neighborhood of $1000 in interest over the next 2 years.

So because the life of the 401k is so much longer, I would pay it off first and invest the money at the same time you are paying off the loan.

I'm not in disagreement with this approach, but I would note that this approach requires the assumption of "modest gains (6% per year)" whereas the alternative approach provides a guaranteed return on every dollar. In fact, if the 401k loan were paid down in Q4 of last year or Q1 of last year, they would have lost $ on what they paid back.

There is also the question of whether sitting on the CC debt and allowing it to grow will necessitate a reduction in 401k contributions in the coming months/years (or not funding a Roth, etc...).

In the end I still favor the sure bet of paying off the CC.

[disneysteve]

Originally Posted by cooliemae

I know this is going against the grain, but I would pay-off the 401k first and here's why

Assuming modest gains (6% per year) on the 401k over the next 25 years the $8000 would turn into $34000.

If you are going to assume a 6% return for the 401k, then you should absolutely pay the credit card first since that has a guaranteed "return" of 12%. There is no way mathematically for the 401k to outperform paying off the credit card unless it earns more than 12% which is pretty unlikely. The time line doesn't matter.

[Slug]

Originally Posted by disneysteve

If you are going to assume a 6% return for the 401k, then you should absolutely pay the credit card first since that has a guaranteed "return" of 12%. There is no way mathematically for the 401k to outperform paying off the credit card unless it earns more than 12% which is pretty unlikely. The time line doesn't matter.

I think cooliemae is referring to the long-term effect of compounding in the 401k vs. a much shorter albeit more costly time period for the CC.

[InDebtInDC]

There is a school of thought that believes that you should not touch your retirement account at all. Following this prescription, the OP would pay off the loan from the 401(k) account and never borrow from the 401(k) account again.

Please don't shoot the messenger

[cooliemae]

Originally Posted by disneysteve

If you are going to assume a 6% return for the 401k, then you should absolutely pay the credit card first since that has a guaranteed "return" of 12%. There is no way mathematically for the 401k to outperform paying off the credit card unless it earns more than 12% which is pretty unlikely. The time line doesn't matter.

I would have to disagree that "time line doesn't matter." My wife started contributing to her 401k plan 1.5 years after I did, she puts slightly more in her 401k each year than I do, but because I started contributing earlier than she did, I'll have almost $100,000 more (assuming out contributions stay the same) when we retire!

Time does matter and I agree that raiding retirement funds should be an absolute last resort.