Save or Payoff Debt Aggressively?

[daverph]

I need advice on what to do. My wife has been at home with our son for the past year and a half. In that time we have lived on my income of $98,800. Due to student loans for both of us and some bad debt this has just about let us keep up, ie we have not added new debt but we have not been able to save or pay off debt other than regular payments. Now she is looking to go back to work and aggressively seeking a job. So my question is should we at least get the match on our 401ks (which I have not been able to thus far) and then attack debt and save what we can or should we put all our money towards the debt and save some on the side. We are looking to buy a house soon. The debt in question is a 28,000 debt consolidation loan at 20%. I pay 800/month now with the minimum at 750 to pay it off in 5 years. When my wife starts working we would most likely be able to pay 1100-1200 per month and then save around 300-400 month. I am banishing the credit card to business use only and then when my company gives me a corporate card then its gone for good. So does it make sense with this much debt to forget about the 401k for a while and start fresh when the debt is paid off. It should take about 2 and 1/2-3 years to pay it off at this rate, longer if 401k is contributed to. Also, bonuses, etc will be dumped into the debt as well.
Thanks.

Dave

Dave

 

[W2R]

It's your choice, of course. Personally I would fund the 401K first, and use what's left over and whatever extra I can save by LBYM, to pay off the debt.

 

[bbbamI]

Am I correct thinking that your loan is at a 20% interest rate? If so, are you unable to get a lower rate?

 

[cute fuzzy bunny]

Hmmm...20% interest on the debt, compounding or ??% tax savings funding the 401k plus the match (whatever it is) and ~8% annual investment gain.

Should be pretty easy to do with a "how much does this loan cost me" calculator and a "how much will my 401k be worth" calculator. Both readily available.

Do note that the 20% interest rate on your debt is a "sure thing", while the 8% investment gain is an average over the long term. Your actual results in 5 years (the term of the debt) might be a loss of 50% of your 401k's daily value.

 

[MasterBlaster]

The payback on the 401k match is 100 percent plus whatever it earns in the market. The interest rate on the loan, although outrageous, at 20 % is significantly less than that.

So based on rate comparisons I would say take the company match.

However you also need to find a way to pay off that debt. That debt is stoping you from funding a retirement nestegg. If you don't pay it off then you will never get ahead.

 

[Webzter]

At least consider these questions...

What's the company match? Will her working put you both in a higher tax bracket? Do you have any emergency funds saved up? How stable is your job? How stable is her job? Can you sacrifice anywhere else?

One potential benefit to paying into your 401k is that your adjusted gross income is lowered. this may keep you in a lower tax bracket as well (less taxes all around). That, plus the match, plus the potential long-term gains should be weighed against the fact that your current debt load severely limits your options.

 

[daverph]

Answers to Webzter

We have no emergency fund saved up that was one reason I am reluctant to put money in my 401k. Her working will not affect us that much, she will not make much but it will be a significant help. My job is extremely stable. Thanks for replys. I want to save in the 401k but I hate having the debt and I want to add more to my emergency fund, well I want to create one at least. Thanks.

Dave

 

[jnojr]

Depending on the 401(k) match, I would personally hit that first. In my case, my employer matches 10% of 6% of my salary, so I would attack the debt. But if you can get 50% match, or something else really nice, then get that. Second priority, kill debt. Eat Ramen and mac'n'cheese until that debt is dead. Being in debt sucks your life away in so many ways. Getting free of debt is a great thing.

 

[daverph]

Match

Match is 50% up to 6% in cash right along with my contribution, vested over 5 years. I don' t eat ramen or mac and cheese but we live pretty cheap and we try to avoid spending but there is only so much you can do, we get bored and lazy sometimes. I should be getting a big raise at the end of the year so that may make it more managable. I figure if you don't have much money how can you not take free money, so I guess I should go with my gut and then work hard to pay off the debt and get some emergency savings. Thanks to all

Dave

 

[Webzter]

I guess I'd probably do enough for the match, stay the course with paying off debt, and see what you can do otherwise. Maybe you can swing a cheaper interest rate a bit down the line. One option, since you're aggressively paying down debt, would be to call your creditors and ask them for a lower rate. I've been surprised, but several times the front-line service reps have been able to knock 3-4% off of our rate without needing approval from anyone higher up. That helped us with our cards a few years ago.

 

[Animorph]

Given that the company match is only 50% and is only a one time event, I might lean towards removing the debt that is going to accumulate at 20% every year. If it takes more than 3 to 4 years to pay off the last of the debt, you may be better off putting all money into the debt. If you can pay off the debt in less than 4 years while contributing to the 401k at the same time, then you can contribute to the 401k.

$100 debt after three years at 20% simple interest is $100 *1.2 *1.2 *1.2 = $172.8 that you will owe. In 4 years it is $207.36

$100 in 401k is $150 *1.08 *1.08 *1.08 = $188.96 In 4 years it is $204.07.

So your net worth looks better contributing to the 401k only if the debt is payed off before 4 years.

Add to that that your money is tied up in the 401k when you probably need an emergency fund, I lean towards paying off the debt. When you are in sight of having the debt payed off, then you might reduce the debt payments and start contributing to the 401k. Maybe if you can still pay it off within a year or so.

Dan

 

[Olav23]

I personally would pay off the debt, with that kinda interest rate. Talk about usury!

One trick you might be able to try if they are unwilling to reduce the rate even after a good payment history, is to let them know you are planning to balance transfer the rest of the debt to another card since it "has a significantly lower interest rate". Hopefully they won't call your bluff, and want to keep the money rolling. If they call you on it and say, feel free, just thank them for their time and hang up. Nothing lost

Is that maybe an option for you in reality? Or is your credit shot and that is why you are in consolidation?

 

[Coach]

Dave, I just want to compliment you and your wife on what sounds like a real commitment to not spending. I admire your plan to get rid of the credit card. Whether the dollar you don't spend goes to saving or to paying off debt, the most important, and valuable thing, is in the not spending.

You might want to check out Dave Ramsey's The Total Money Makeover at the library. It will help you develop a plan.

Coach

 

[Darryl]

If you have buy a house on your to do list. I would get after this debt before I did anymore with the 401K. You need a down payment more emergency funds available than a renter would need and a better cash flow than you are describing. Get serious about this at your income level and you could knock it out in a little over a year and you'll feel a lot better. "Beans & Rice"

 

[daverph]

Must still buy a house.

We also want to buy a house in the next year or two as well so I want to get some good emergency funds built up and the debt paid off or at least down significantly.

 

[cute fuzzy bunny]

If you're pretty secure in your job, and highly employable, instead of holding a lot of cash in your emergency fund, you can put a little more down on the home you're going to buy and use a no fee/no cost home equity line of credit as your "deep emergency" fund.

So instead of having 6+ months of pay in the emergency cash fund, you'd only need 2-3 months, with a HELOC available to tap if needed.

Only danger there is you lose your job, cant get another one for six months, and something else horrible happens all at the same time.

But if you've gotten used to holding 28k at 20%, that unlikely prospect probably wouldnt scare you too much.

 

[daverph]

Job loss not an issue

I am a pharmacist in management so I am very stable in my job. In fact my boss heard a rumor that I was looking to leave and called me begging me to stay saying how irreplaceable I was. We will see how much so at raise time, haha. Even if I did lose my job I am well known in my industry so finding another job would not be a problem. I would rather at this point accumulate a nice emergency fund so I never have to use a credit card again and pay off my debt so that I can save and invest without obstacles.

 

[FinanceDude]

I am a pharmacist in management so I am very stable in my job. In fact my boss heard a rumor that I was looking to leave and called me begging me to stay saying how irreplaceable I was. We will see how much so at raise time, haha. Even if I did lose my job I am well known in my industry so finding another job would not be a problem. I would rather at this point accumulate a nice emergency fund so I never have to use a credit card again and pay off my debt so that I can save and invest without obstacles.

You background makes you EMPLOYABLE for the near future.........so take a stick and whack that debt away, and things will fall into place.

I remember a game I played back when I had little net worth, I used to say these corny words out loud:

$1 towards debt, $.10 towards fun, $1 towards debt, $.10 towards fun...........

 

[jazz4cash]

Hmm...I was in very similar situation many yrs ago when our kids were babies and two things saved me:
1. Do whatever it takes to get a reasonable interest rate on the debt.
2. Keep contributing to the 401k to at least get the match........it really felt good to know that no matter how bad things were, I could afford to save. The 401k was also our emergency fund

If you can't get a better interest rate (at least 10% or less), this could be a situation to consider a 401k loan

 

[EngineeringMyFinances]

I'd find it tough to give up the free money from employer's match. Particularly since you indicate that your employment is secure and therefore you'll be vested in the employer match soon, if you're not already. But given the high interest rate, maybe it's better to pay on your debt -- for awhile. Doesn't take too long while compounding at 20% to eat up a 50% match.

If you decide to concentrate on getting rid of the debt, re-evaluate your situation periodically. After a period of aggressive payments, you'll be closer to having it paid off, so the balance will tilt towards starting up your 401k again when analyzed along the lines that Animorph outlined. And maybe with a smaller debt, you'll be able to refinance at a lower interest rate.

The 401k plan provided by my employer matches 50% during the first 5 years of participation, then 100%. If your plan had a similar provision and you have less that 5 years participation, I'd through in 2% of salary just so I'd be participating.

Also you should consider your period of non-participation in your 401k like a loan. After paying off your debt, you should continue making payments and switch them to your 401k, increasing contributions above what the employer matches until your "loan" is repaid.

 

[Sam]

20% interest? That's mind-boggling! What kind of debt is that?

Your job is stable, you make 98K a year. Can you get a 28K personal loan from a bank?

 

[Ed_The_Gypsy]

Also you should consider your period of non-participation in your 401k like a loan. After paying off your debt, you should continue making payments and switch them to your 401k, increasing contributions above what the employer matches until your "loan" is repaid.

I agree. I would pay of the loan as fast as possible, then continue the payments into your retirement account(s). The 20% is after taxes. If this were an investment, consider you tax rate. If your tax rate is 28% (wag), before taxes, it is roughly equivalent to 20/(0.72)=~28%. You can't get a guaranteed return on investment this good anywhere. You want to get rid of this ball and chain.

 

[chinaco]

Pay off the high debt first.... ASAP!

 

[Eyerishgold]

What makes this decision a whole lot easier is the interest rate you're paying on the loan. 20% (ouch). Unless you can get better than a 20% return investing your money, I'd definately pay off the debt first.

 

[BigMoneyJim]

A thought or two: To keep the 401(k) match you must be vested. If you're already vested, the match is very powerful, and the reduction in income taxes you get helps, too.

When I was on a debt-eliminating streak from 2001-2005 I was single, renting, had a secure job and was vested in my 401(k). I was also able and willing to relocate if it were to become necessary. Given these circumstances I contributed more than the match to my 401(k), paid my debt down aggressively, managed to get lower interest rates and had no after-tax savings (emergency funds).

I plotted things out and found that there was a most efficient ratio between savings and debt reduction after taking into consideration matching, tax savings and cc interest charges during the period of the debt elimination. However I chose to be more aggressive in paying down my debt and less efficient (in theory). In other words, on paper there was a savings/debt-reduction split that would have left me with more money than other splits.

I sold my nice truck and bought a sedan that was more fuel efficient, had lower payments, cost less overall and cost less for insurance.

I was able to consolidate my debt onto a family member's low(er)-interest rate card. That helped a lot, but mixing finances and family is rarely advisable.

I guess the summary is that how you split your 401(k) savings, after-tax savings and debt reduction is a personal choice. There may be a most efficient split on paper, but you have to consider other factors like how much it would hurt to lose income, have to move, etc.. But whatever the choice, there are many ways to reduce your expenses and interest rates that may not be immediately obvious, and those help no matter how you split your money.