Should you pay down your debt or save away for retirement? It’s a tricky question and it all depends on what kind of debt you’re talking about and what kind of retirement funds you’re contributing to. Let me illustrate this with two different examples.
John Smith has lived a very lavish lifestyle and is now about $25,000 in debt to credit cards paying an average of 15% interest. John, who has since mended his spendthirft ways, is thinking about saving for retirement and doesn’t know whether he should contribute to his 401(k) or pay down his credit card debt. His company offers a dollar for dollar match up to 3% of his salary on his 401(k) contributions. So, should John pay down his $25k debt or contribute to his 401(k)?
His debt of $25k at 15% means he’ll be paying $3,750 in interest each year. Unless he made $125,000, he wouldn’t be able to get a company match of $3,750 (ignoring the Highly Compensated Employee contribution limits, which surely would kick in if he made $125k) to make contributing to his 401(k) “worth it” from a straight match perspective (ignoring the income tax on the disbursements in retirement). So, what should John do? John should take his contribution amount and sent it ot the credit card company so he can get out of his debt.
Now let’s say that John has a $25,000 Home Equity Loan at 7%, now we’re talking interest payments of only $1,750 each year and that $1,750 is tax deductible. If John made over $58,333.33 in salary, his contribution of 3% would generate an employer match of 3% that would offset that interest payment. See how the profile of the interest makes a difference?