Karen asks a good question. What should you do first? Pay off your debts or start a savings program? While there's probably no one answer that's right for all situations, let's see if we can't put together a plan that will work for most people.
We'll start at the beginning. Before you can decide where you want to go, you need to know where you are. Karen has already taken that step and knows what her income and expenses are. That's a vital part of any successful plan. If you don't know how much income you have after your bills are paid, do that first.
Next you'll need to consider the different opportunities open to you. Take Karen's situation. After her normal monthly bills are paid, she has some options. She can continue to pay off her credit cards. Or she can add money to a retirement account (in this case a 401k plan). Each individual will have different options available to them. What's best for Karen?
Let's consider the purely financial aspects. To do that we're going to look at each choice individually and try to figure out how much money we'll make if we take that option. Our goal will be to calculate a rate of return over a logical number of years.
For instance, if Karen has credit card balances at 18.9% any money she pays above the minimum will in effect earn an 18.9% return for her. That return will be the same each year until she has that particular credit card paid off. Then the return will be the interest rate on the next card she's paying.
Another option would be to put the same amount into the 401k plan. The money she puts into the program is not subject to income taxes. So at the 15% bracket, Karen would save $150 in taxes for every $1,000 she would invest. So she's made 15% before she even invests the money. Sounds like a good deal. In addition, any money earned within the plan isn't taxable until you take it out of the plan at retirement.
Is there a way to compare the two choices? Yes, as a matter of fact, there is a way that you can estimate it without getting into some crazy math. It won't give you an exact answer, but you will be in the right ballpark.
We know what Karen will earn by paying off her credit cards. It will be the rate of the highest card outstanding. In this case, that's 18.9%. Karen's letter didn't provide all the needed information, so we'll have to make some assumptions. We'll assume that by paying more than the minimum she should pay that one card off in a year. If, however, she puts the extra payments into the 401k plan, we'll assume it will take her five years to pay off the balance.
So what's our return on the 401k plan over a five year period? Naturally, that will depend on the investment. Investment selection is another big topic that we won't get into today. But since we have a guaranteed return if we pay off the credit card, let's pick something that's fairly predictable. Perhaps a fixed income type of investment that earns 8%.
What will we earn over the five year period? To calculate that multiply the rate per year (8%) by the number of years (5). We'll need to add in the 15% tax savings that we get the first year, too. So our total is 55% (8% x 5 = 40% plus 15%). That's 11% on an annual basis (55% divided by 5 years).
Suppose Karen's company would match her contribution at the rate of fifty cents per dollar she contributes. What then? You just add that into the calculation. Your return would be 40% (8% x 5 years) plus 15% plus 50% or a total of 105%. That works out to 21% per year (105% divided by 5 years).
In Karen's case we actually get a better return by paying off the debt. I'm sure that a number of you are saying that we didn't include the effects of compounding. And that's true. But this is just meant to be a quick way to estimate which gets the better return. If you need real accuracy, there are financial function calculators available for $20 that can get you to the exact return.
Another thing to consider is how do you relate to money. Are you disciplined enough to keep paying more than the minimum on your credit cards? And once you've reduced your balances can you refrain from running them up again? If not, you might need the discipline of the 401k contribution. It's deducted from your paycheck before you see it. That way it's like you never had the money at all. Remember, our comparison assumes that you do, in fact, pay off the credit cards. If you don't your return is 0% and you'll do better by putting the money in the 401k.
There's another psychological advantage to reducing the credit card balances. You'll feel like you're achieving your goal as the balances drop. Each time you complete paying off a card you'll be inspired to continue your quest.
One final thought. Sometimes it's hard to make a decision. But doing nothing in this case is the worst decision you can make. You won't be saving for retirement or reducing your debts. If you just can't make a decision, put half of the available money into the retirement account and half into repaying debts. At least you'll be moving towards your goals.
While there's no one right answer for every situation, with a little thought you can decide what's best for you. We wish Karen the best as she provides for a more secure financial future.
Gary Foreman is a former financial planner and purchasing manager who currently edits The Dollar Stretcher.com website and newsletters. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report and he's a regular contributor to US News Money and CreditCards.com. You can follow Gary on Twitter or visit Gary Foreman on Google+.
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