Pay off debt or save? A quandary that is deceptively complicated

By BOB CUNNINGHAM

Another personal finance blog’s post on this subject caught my attention recently, and it got me to thinking that the question of whether to pay off debt as soon as possible, or maximize saving and investing, must be among the most-asked by Americans interested in smart money management.

The easy answer is to do both – after all, especially in the world of finance, how can diversification be a bad thing, right?  And the truth is, for most folks, paying off some debt and saving some money, too, probably IS prudent.

But there are factors that many gurus don’t properly consider, especially those who happen to come down particularly hard on either side of the aisle.

In the get-rid-of-that-nasty-debt-at-all-costs camp, the reasoning for paying off a 23% APR credit card ASAP is difficult to assail.  It’s sort of like an instant 23% return on your money… yeah, sort of.  Certainly, being able to ratchet that balance down rapidly is beneficial – a $120 minimum payment on $5,000 of credit card debt at 23% nets only about $24 going to principal, the other $96 pure interest profit for the company which issued the plastic.  That’s why you can end up paying nearly $20,000 to erase that debt if “you go the distance,” and just pay the minimum required each month.

But whenever you add money to the minimum, you have to figure the lost opportunity cost of not having that cash invested in a compounding account instead.  In other words, the interest goes both ways.  True, that performing asset is likely to fall way short of a 23% Rate Of Return, but in getting the money into the account earlier, you reap the rewards of more interest accrued long-term because of the magic of compounding.

The invest-as-much-as-you-can-and-don’t-worry-so-much-about-the-debt crowd, meanwhile, conveniently tends to overlook the lack of liquidity in most of the alleged best investments.  Want to build up your 401K and then use some of those funds to pay off that credit card?  Forget it.  Unless you’re turning 59 1/2 and are prepared to quit your job, it’s unlikely that will be an option for you.  And borrowing against your 401K generally defeats the purpose.

Also, don’t forget you will be paying taxes on your accrued savings when you finally do access it.  With the beefed up credit card payments, it’s after-tax dollars already so you get the full bang of your bucks toward eliminating principal.

I know… I haven’t really answered the question of which is wiser.  Well, here are some basic numbers using the following scenario:  An individual we will call Titus (why not?) is faced with a choice.  He makes $3,000 per month gross salary, has no savings yet, and owes $5,000 on a credit card at 20% interest with a minimum required monthly payment of $100.  His 401K at work offers a 50% match on up to 5% of his gross income, and is returning an average of 7.5% annually (figure 10% minus the typically exorbitant 2.5% of fees).  Lastly, Titus has determined he has $300 per month extra to dedicate either to savings or debt elimination.

If Titus opts to go after his credit card debt, at $400 per month ($300 extra plus the $100 minimum required payment), he will have his $5K debt paid off in about 15 months, after which he plans to put $300 monthly toward his 401K and improve his current standard of living with the $100 extra per month for discretionary spending.  After five years from the start of accelerating the pay-down of his debt, Titus has about $21,000 in his 401K with no debt. He achieved this with his $300 plus $75 from the company ($3,000 salary times 5% = $150 times 50% is $75), for 45 months. He went from minus $5,000 to plus $21,000.  Pretty sweet.

If there had been no company match, incidentally, he would have a little less than $17K.

On the other hand, if Titus chose to pay the $100 minimum on his debt and instead put the $300 toward his $401K, along with the $75 match, it would amount to about $27,000 in five years minus the $3,800 he would still owe on the card for a net gain of roughly $23,000.  Sans a company match, the net gain would be about $18K.

But before you key on $23K being more than $21K, one other factor needs to be considered:  Remember that Titus would not have the option of using the 401K money to pay off the $3,800 credit card balance, so that debt would continue charging 20% interest annually.  Chances are that this ongoing liability eats into (or completely decimates) what is otherwise a relatively small advantage for going the 401K route.

In the end, it is the company match of the 401K and the interest we credited in this example that pushed the pendulum towards not accelerating the pay-off of the credit card initially.  But what if we endured a down market during this five years and the return was only 3%?  Wouldn’t that make paying off the debt come out significantly better?  Yep.

Ah, and remember that Titus took $100 a month after the debt elimination and began using it as extra spending money.  He improved his budget flexibility, and that’s a tangible gain too.  I incorporated this into the example because it’s my opinion a large percentage of folks, faced with having $400 to “play with” after eliminating a debt, would choose to have fun with a portion of it.

Ultimately, in my opinion, a credit card debt at 20% interest should be your first and only priority because it is definitive, non-taxed progress.  Opting to contribute to the 401K up until the company match is maxed and then turning your attention to the credit card debt certainly is logical – you’ll never get a truly dissenting vote from me even if the math leans otherwise.

But ignoring the available acceleration of paying off big debt in order to pad your retirement account contributions is essentially leaping over dollars for quarters.

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DISCLAIMER:  This post represents the author’s opinion only, sometimes based on and supported by cited numbers and sometimes not. In no way should any part or all of the content of this post be interpreted as official financial advice, nor does it represent an intention to solicit readers into a specific strategy or investment.  Profitability is NEVER guaranteed.  Invest at your own risk.