A Common Money Dilemma: Payoff or Invest?

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Personal finance can be defined as all financial decisions and activities of an individual, including budgeting, insurance, savings, investing, and debt servicing among other things. It’s been said that money makes the world go round and yet personal finance is something many learn from their parents and friends, through word of mouth, or tidbits of information found in fine publications such as this. Recently Virginia has required that financial literacy be part of the high school curriculum that all students must complete before graduation. By learning financial decision-making skills early, they will be better prepared to tackle some of the common money dilemmas that adults face every day.

 
One such dilemma is—do I pay off a credit card or fund my 401(k) with my excess funds? The answer is not simple and varies from person to person depending on their circumstances. However, there are some steps you can take to figure out which option is best for you.
 
The first step is to gather the information on all the variables. These include the interest rate on the credit card, any company 401(k) matching details, the historical return of a diversified 401(k) plan, yearly salary, and personal tax bracket rate. 
 
Keeping that in mind, let’s create a scenario to demonstrate how to determine which answer makes the most financial sense for you. 
 
Today the average American credit card carries an interest rate of about 14 percent so we will use that as the credit card interest variable. Companies vary greatly on their 401(k) matching programs, as some will match 100 percent on the first three percent the employee puts in while another may match 50 percent on the first six percent the employee contributes. For the sake of our scenario, we will use a company match of 50 percent on the first five percent the employee contributes as the variable in this calculation. The performance of 401(k)s will vary year by year depending on market conditions, but using the historical average of eight percent return in a given year will provide a good rate of return over the long term. This person will have an income of $48,000 per year or $4,000 per month in gross salary. The personal tax bracket in this scenario will be 30 percent, which will be the combined federal and state taxes. 
 
With these variables one can compute the monthly payment of each choice. The 401(k) will have five percent of the monthly income ($4,000) that translates to $200 a month, with a company match of $100 for a total of $300 a month into the 401(k) plan. The credit card option has to be paid with after-tax income or take-home pay so the same $200 a month becomes $140 a month after-taxes that can be applied toward the credit card. From the beginning it would seem like the $300 a month of increased assets is preferable to the $140 decrease in debt. This is where the different rates of interest come into play, as there is a time value of money consideration. 
 
The 401(k) option of $300 a month for 3 years (or 36 months) growing at eight percent a year calculated monthly results in a 401(k) balance of $12,161. Should there have been zero growth in the market, however, the balance would only have been $10,800 and even lower should there have been negative growth. To get to a number that is comparable to the other option we will then calculate the after-tax balance to be $8,512 by taxing the $12,161. 
 
The credit card option of $140 extra a month applied to the balance over 36 months would result in a savings of $6,219 via a $5,040 reduction in the balance and $1,179 in reduced interest. These savings are guaranteed and not market dependent but may vary if the interest rate on the card changes. While this result shows that over a three-year period the 401(k) option results in a larger balance than the credit card savings, over the long run the higher rate of the credit card interest will overtake the 401(k)’s rate of return. For this example the credit card option would overtake the 401(k) during the 134th month and then proceed to outpace the 401(k). 
 
In our scenarios, this individual would be better off to apply the extra funds at their disposal towards paying off the high interest rate credit card and then shifting to the 401(k) when the credit card is paid off. There are many variables in these calculations so the decision outcome may differ, but educating oneself in personal finance always will result in a positive value through the knowledge gained. Seeking the advice of a financial advisor is always recommended if you are not sure of your calculations or simply want a second opinion.
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