Save Or Pay Down Debt?...(continued...)

Last week, I told you about my experience speaking at the Garrett Planning Network retreat, and shared a question I invited the financial planners to answer. Here it is again:

 Q: I have $5000 in credit card debt. I just got a new job with a 401(k) plan that provides a small employer match. Should I pay down this debt first or keep making small monthly payments and max out my 401(k)? I can’t afford to do both.

Michael Knight, CFP ® with Knight Investment Planning, LLC says:

You posed a question to the group regarding advice for a client who has $5000 in credit card debt and the right choice to make between debt reduction and funding a 401 K. My advice would be to recommend that the client fund the 401 K up to the limit for matched funding and then temporarily direct the cash flow to eliminate the debt.

Jeff Kostis CFP ® of JKFinancialPlanning agreed, and went into more detail:

This person should look at the company match as a guaranteed return on his investment. Since most companies match between 50% and 100% up to a stated amount, the employee is getting a guaranteed return between 50% and 100%, PLUS any return on the investment itself.

As an example, assume the person is making $25,000 per year and the company matches 50% of the first 3% in contributions. The employee will contribute $750 during the year (3% of $25,000), and the company will add $375 to the employee’s account (50% of $750). At the end of the year, the employee will have $1,125 ($750 + $375) in their account, after only contributing $750!

This is probably the only time in life that an investor truly gets a high guaranteed return with no risk. If the employee happens to get a 5% return for the year, the ending account balance will be $1,181. The return on the account is not just 50% or 55%, but 57.5% since the person also earns the return on the match portion.

This being said, the person still needs to pay down their credit card debt with any extra money. By definition, having credit card debt means that the person spent money they didn’t have. If that spending was made for important things like medical care or frivolous things like eating out, the person still spent money they did not have. The person needs to make lifestyle changes today to pay for the things they bought yesterday.

Sean Burgess of Burgess Financial had a different take:

Pay off the credit card first. This will give you a guaranteed "return" of 12-15% (based on current average credit card interest rates).  Once this debt is eliminated, direct your funds into your 401k plan taking advantage of its tax benefits and employer-matching contributions.  While the employer matching contribution is tempting, you will actually come out ahead by paying off your debt, putting an end to the drag of interest payments as soon as possible.

Gerri Detweiler – Personal finance author and Credit Advisor for Credit.com. Gerri contributes budgeting, debt recovery and savings information online. She is also the co-author of Stop Debt Collectors: How to Protect Your Rights and Resolve Your Debts