Should I pay off my credit cards or max out my 401k?

questionIn the unending “pay off debt first or start investing” debate, I’ve learned about a small wrinkle:

If your employer matches your 401k contributions, you earn an instant 100% bonus on every one of those dollars. In the worst of scenarios, your credit card company is charging you interest in the high 20s.

The Big Disclaimer: None of this is intended as advice, nor should anyone reading make large life decisions based on this content or subsequent discussion. I’m just starting a conversation here; each person should evaluate his/her own unique needs and circumstances before making any important financial decision.

In other words, in cases where you haven’t reached your maximum employer match, the math tells you to prioritize 401k contributions ahead of paying off high interest credit card debt. Once you’re getting every matched dollar you can from your employer, the math says to throw the next dollar at your credit card debt.

That’s the strict math, but what might change the equation and tip the scales back toward a full focus on the credit card debt?

If a person can’t make the required 401k contribution and keep all bills paid and debts current – the math doesn’t matter. He can’t afford to “buy” the matched dollar from his employer.

If that same person is pushing every extra penny to credit card debt, and views the freed up credit card availability as his “emergency fund,” redirecting the money to his 401k for the sake of the match could create excess risk in his finances.

Sure, he could borrow the money back out of his 401k, but that carries its own risk:

  • He loses investment growth on the dollars borrowed from the 401k.
  • The loan has to be paid back with post-tax dollars (which means the payments will reduce his take-home pay).
  • If he leaves his current job, the full 401k loan could be due within 60 days, creating a situation where he still has the credit card debt, still has no emergency fund, and now has to come up with the money to pay off the 401k loan.

Although I don’t have any credit card debt, here’s how I would approach this problem:

If I were snowballing credit cards with extra money, I’d prioritize matched 401k contributions ahead of paying off debt. You just can’t beat an instant 100% ROI.

But, I’m working on the major assumption that the hypothetical borrower has broken the borrowing habit – maybe even closed/cut up the credit cards – before heading down this path.

This is all on my mind because I recently had a friend go through this process. He was snowballing his credit card debt and realized he was leaving money on the table by NOT getting his full match. He reallocated snowball money to get the full match, then did a consolidation loan through Lending Club to pay off his credit cards (and get a much lower interest rate). For him, it’s a big win in terms of interest NOT paid and interest earned.

This entry was posted in Debt, Investing by mark. Bookmark the permalink.

About mark

Mark has been working online full-time since 2008, owning an educational website and two small software businesses. He joined YNAB (as Blogger/Staff Writer) after selling his businesses in late 2012. In addition to his love for budgeting and personal finance, Mark enjoys hanging out with his wife and two kids, snowboarding, CrossFit, bike commuting, and tinkering with side businesses.

28 thoughts on “Should I pay off my credit cards or max out my 401k?

  1. I’m trying to pay off my Pre-YNAB cc debt, and car, as fast as I can, with a goal of November 2014. I recently lowered my TSP contribution to 5%, the max Fed. govt match, and am throwing that extra $200 each month at my debt. As soon as those 2 are paid off, I will raise back up to 11%. Potentially more as I will receive a step-increase (small raise) in the meantime.

  2. My comfort is in not having CC debt – regardless of the math, that’s what “feels” best to me.

    Keep in mind that you can always stop or lower your 401(k) contribution in case of an emergency or change in income. You cannot skip your minimum credit card payments without repercussions and skipping just ONE can lead to late fees, penalty interest rates, over-limit fees, etc…

    I would also argue that if you have an employer match 401(k) and a 20% interest rate credit card, your ROI is not 100%. It’s at best 80%. Every dollar you put in the 401(k) to “buy” the match dollar instead of pay off the debt means you have to send 20 cents to the credit card company to pay interest for that dollar. Your net gain after paying the interest is 80 cents – not 1 dollar.

    Pay off the consumer debts – especially credit cards that are not backed by something of value that you can liquidate – as soon as possible. Save later. That is what has felt right for me. The risk of the debt is not worth it.

    • You’re right – matching 100% but paying 20% is only 80%. That still makes the difference 80%, without any return at all on the actual 401k investment. Further, if you apply this in the other direction, when you pay off those 20% credit cards, you’re losing the 100% match – so for every dollar you put towards debt rather than 401k is a loss of 80 cents.

      I agree that there’s a discomfort with carrying the debt any longer than you absolutely have to, and its difficult (or maybe impossible) to quantify that – but an 80% difference is worth thinking about.

    • If your employer doesn’t match, the interest earned in the 401k can’t begin to compete with the interest paid on the credit card debt. Get rid of the debt, then invest.

      • Doesn’t this depend on the interest rate on the credit card debt and your tax bracket? If your tax bracket is 25% and the credit card is 9%, aren’t you money ahead by diverting it to the 401(k) (even assuming no employer match)? Obviously, you’re at risk for the interest rate on the cc debt going up. Also, there’s the question of the return on the 401(k) investment.

  3. What about other debt? I always hear people talk about paying off credit cards before investing but what about student loans? I have $30,000 in student loans ranging from 2.8% to 4.75% and am never sure whether to snowball them or max out my HSA, Roth IRA and 401k match first. I’m currently doing the later but am always a little worried if I’m making a mistake!

    • That’s a tricky one, Rachel. It really all depends. I think the Roth money is the hard part of that equation. Can your investments, after inflation, beat the 4.75%

      I’d definitely keep the 401K going, at least up to match. And keep going with the HSA. The HSA is just a great investment vehicle depending on your situation. You put the money in tax fee, including FICA. So you are not paying any federal income tax, most states you don’t pay state income tax and you dont pay the 7.65% FICA tax. Someone in my state, in the 25% tax bracket, would get a 38.65% return on taxes for that money. Then it gets to grow tax free. And, if you use that money for future health or nursing costs, you can withdraw it tax free. A triple tax advantage.

    • I in a similar boat and I’m putting the money in investments. My current payment plan would have the loans eliminated in 4 years. If I diverted all my investment payments, I could move the deadline up 2 years. However, that is 2 years of 401k, IRA, and HSA contributions that I can never get back. That’s over 52k if I were able to max everything out. That’s not even including the tax savings and future interest gains. I just don’t picture the student loan interest (in my case) exceeding that with the 2 extra years.

  4. I was in this exact situation about 4 years ago. I decided to focus entirely on paying off my debt. After all my debt was paid off (except or the house) I then focused on investing & paying off mortgage. I was amazed at how fast the investing accounts increased with no debt load! It felt wonderful.

    A couple months ago I was laid off from my job. With no consumer debt – it has been a lot easier (or maybe less hard) dealing with the loss of income. It has been a great blessing having no debt, and a great savings & retirement.

    I would always vote for pay off debt!

    • I totally agree – you should pay off the debt as soon as possible. If something happens you cant access your retirement money to get you through it. You will still have to pay all of the debts off.
      Whilst it may not make mathematical sense its a much better thing for you to do for your financial security.

    • Yes, it’s better to pay off the debt first.

      (1) the “math” in the blog article doesn’t address the RISK of keeping that debt while you invest in the 401k. The march might help you build up a nice little fund but it doesn’t matter if you lose your job or have emergency expenses and have to pay taxes and early withdrawal penalties to extract that 401k money. You may be “leaving money on the table” by foregoing the match – but you are leaving unquantified and unseen risk on the table by continuing to carry the debt.

      (2) money mgmt is more about psychology than math. Think about your post on your “single financial goal”. Trying to split your attention between saving and paying debt is unfocused and confusing. You can get better results by applying an unrelenting focus on clearing away the debt, and then be free to invest without the hidden risk and dispersed focus brought on by carrying debt.

  5. Where does house fall in? My wife and I are currently renting, but we really want to buy. Right now we’re in a debt snowball (student loans and car) and after that we’ll dump all the former debt payment into down payment savings. In light of this plan I reduced my 401k contribution down to 1% and yes my company does do a match also. I chose 1% because I still want to be in the habit of contributing. What do ya’ll think?

    • You just can’t beat a dollar-for-dollar 401k match in terms of instant return on investment.

      Just my opinion – giving up free matched dollars to build your house down payment doesn’t make financial sense. If that were me I’d max out the 401k match and save for the down payment after that.

      In fact, that’s exactly what the friend mentioned in the post is doing.

      • It is not actually an instant return for some plans/ companies. The 401(k) match may in fact not be vested right away. Some companies only provide that money if you leave after 3 years of participation. Every plan may vary so if you don’t think you will stay in that job that long, then the match may end up being forfeited.

  6. Any thoughts on being self employed…a few low interest debts, student loan at 3.5, a personal loan at 3.5, a truck loan at 7.4. We are both self employed and have about 1,000 a month we can use toward snowballing debt or saving and investing.

    • The main point of the post is to encourage people to take full advantage of the “free” money they can get through employer-matched 401k contributions. If your employer matches, you want to get every penny you can out of that match, and it *might* make sense to prioritize the match ahead of paying off credit card debt.

      If your employer doesn’t match contributions, forget about the 401k until your credit cards are paid off. After all, that promotional interest rate won’t last forever.

  7. I’ve been thinking about this, ever since Mark brought up his friend’s example.

    I don’t *like* debt–especially the consumer kind, but even mortgage debt, student loan debt, etc. I have an emotional bad taste in my mouth when I think about maxing out a 401k up to the employer match, and I’m trying to figure out why that bad taste is there, when mathematically it makes perfect sense.

    I think the math doesn’t necessarily take risk into account. Carrying debt is riskier than having money in (semi-locked savings vehicles like) a 401k. I just don’t like that I HAVE to make that debt payment, but I don’t HAVE to contribute to the 401k. I prefer to get rid of the HAVE TOs in my finances first, and then assess what my next priorities are.

    I battle with this question as it relates to a rental property where, as an investor, I have a 2.25% after-tax interest rate (crazy low, imo). Do I really accelerate that principal paydown when I could those funds to invest at double (conservatively), or even triple (quite possibly) the return?

    • It is a difficult decision, I’m kind of glad to see you also struggle with the decision : ) At least with YNAB I have the “problem” of having to decide where to put this extra money I seem to have now! Thanks for YNAB Jesse!

    • I think this is the first comment to mention the expected return. For me it is certainly a factor to consider. And as posted below, you should consider the effects of compounding in your forecasting.

  8. The Math I was always told was pay yourself first. Regardless of Employer Match, 401K is money you earn that is put into savings growing at a COMPOUNDED rate that Uncle Same can’t touch. That means little dollars today become extremely bigger dollars tomorrow. So yes the Interest % says 20 is worse than 8 so pay off the 20 but remember, you are paying off the 20 with LESS money because the money you didn’t put in the 401K took at 15-35% penalty in TAX. Since Caesar is no longer in power I will Render onto Myself what is mine and Uncle Same can take a lot lower cut – maximizing dollars working for me. Then I will sacrifice elsewhere to pay off that 20% interest. Remember if you put 10 dollars into the 401K and decide to stop your not getting 10 bucks to pay down your debt… your only getting $7.50.

  9. What if the employer match is 25% of the first 4% contributed. Would it still make sense to take the max on that if I have CC debt? Thank you

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