Dave Ramsey advises people to not contribute to retirement accounts while repaying credit card debt. This advise seems sound because credit cards charge high interest rates and your investments may not make 10 or 20%. But is this idea still correct when there is a company match, after all an immediate 50% or 100% return is pretty hard to pass up?
To simplify a bit I want to look at two choices: You could put $1000 dollars in 401K with a 50% match or you could take the $1000 pay 25% in taxes and put the remaining $750 toward your credit card. After your credit card is paid off you take the monthly payment and contribute that much to your 401K and getting the employer match and a tax deduction. Because of the tax break you can afford to contribute 25% more without lowering your income. After five years which option earns you more?
And the Winner is…
It depends on the interest rates, but here is a graph that simplifies a lot of complex math:
It turns out that the expected interest rate on the credit card has to be a few percent higher than the expected interest rate from the 401K. I tabulate the numbers below, an example if you expect to get a 6% return on your 401K investment then you should pay off a credit card that is 8.72% or higher.
|Interest 401K||Interest Card|
What about 100% Match or 0% Match?
The results are the same- I was actually a bit surprised but the match % cancels out of the calculations. The above chart does not depend on how much your employer matches- or if they match at all!
For anyone interested, I can send you a spread sheet with the calculations. It’s a bit of a mess because the solution can’t be solved algebraically. You make an initial guess and do repeated iterations that get an ever improving result.