What Debt To Pay First?

[Slug]

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]

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]

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]

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.

[disneysteve]

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

That's a totally different point. You're right about that.

What I meant was that the fact that the credit card would be repaid before the 401k loan didn't matter. What matters in that comparison is the interest rate.

[cooliemae]

I guess I see CC debt and 401k debt as apples and oranges due to their nature.

401k is for the long term and the CC is short term.

Retirement is one of the things that constantly stays in my radar, especially continuing to see that if I want to live my current lifestyle when I retire, I'm going to have to save even more than I currently am.

So while the 12% savings may be a fact, I would advise taking the chance to earn over 35% by paying off the 401k debt first.

[disneysteve]

I guess I see CC debt and 401k debt as apples and oranges due to their nature.

The nature of the debt doesn't matter. It is always financially more advantageous to pay off higher interest debt before lower interest debt. That's what will save you the most money and get you debt-free the fastest.

There are psychological reasons why you might want to do it differently, but from a strictly bottom line, dollars and cents point of view, paying the higher interest debt first wins every time.

[noppenbd]

I guess I see CC debt and 401k debt as apples and oranges due to their nature.

401k is for the long term and the CC is short term.

Credit cards are only short term if you pay them off! Seriously though, keeping high-interest credit card debt around can have long term financial consequences.

[maat55]

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.

The only reason I would consider paying the 401 first, is because if you were to loose your job, that money has to paid back within 6 months or less, or you will penalized and have to pay the tax on it. Otherwise, the CC's are definatly first.

[lp_fatcat]

Hey Everyone!

Thanks for the valuable feedback! I paid off my CC, put the remaining in my EF and as far as the 401K loan is concerned well...

I submitted some applications for a part time job!

Thanks again!

[Aleta]

Congratulations on your decision. At least you had enough opinions to make a decision. You probably knew what you wanted to do from the beginning but needed other opinions to evaluate your decision.

[noppenbd]

I would add my congratulations. I don't think you can go wrong paying down debt. Choosing between the 401k and the CC debt is really splitting hairs if you ask me. Having either one is financially toxic, so whatever you can do to eliminate them will help your situation immensely.

[cptacek]

I submitted some applications for a part time job!

Yeah! Yes, get that loan paid off in any way you can. With the payments going in every paycheck and your part time job, it won't take long.

[CreditExpert]

the credit card is the most costly short term loan, so it will be better to pay that off and then use the cash you have free to pay off the 401k loan asap.