Ask a financial planner: Should I prioritize my credit-card debt or my 401(k) during the pandemic?

Ask a financial planner: Should I prioritize my credit-card debt or my 401(k) during the pandemic?

by Tanza Loudenback
December 10, 2020

Ask a financial planner: Should I prioritize my credit-card debt or my 401(k) during the pandemic?

Ask a financial planner: Should I prioritize my credit-card debt or my 401(k) during the pandemic?

by Tanza Loudenback
December 10, 2020

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Question: If we are having a really hard time paying 100% of our credit card debt down because of COVID, should we still be investing in our 401(k)?

Answer: It sounds like you're already taking advantage of a workplace retirement plan, so give yourself a pat on the back.

401(k)s and other defined-contribution plans offered by employers are some of the best tools for retirement planning thanks to tax benefits and other perks like contribution matches. The earlier you get started, the more time your money has to compound. 

That said, credit-card debt is notoriously expensive. The average interest rate on credit cards — known as APR — is nearly 15%. It's not unusual to see rates above 20%.

Firstly, I recommend calling your credit card company and asking if they would consider giving you a lower interest rate, even if it's just temporary. Because of the pandemic, banks are being lenient right now. They might not be willing to agree to a rate reduction if you have a spotty payment history or low credit score, but asking won't hurt. 

From there, I see two clear options for balancing investing and debt repayment:

Option 1: Stop investing and put all extra cash toward the debt balance

Let's assume your credit-card interest rate is around the average of 15%. 

That's quite a bit more than what you might be able to earn through an investment account, like your 401(k) (remember that returns aren't guaranteed in investing). The average stock market return over the past 10 years is about 9% before taxes. 

When you compare apples to apples — interest rates, in this case — you'd "earn" a much larger return by going all in on your credit card debt. And it's guaranteed. 

So, the first option would be to pause your 401(k) contributions and put all your extra cash toward the credit-card debt. Once the balance is paid off, resume investing. 

What you should avoid is pulling money out of your 401(k) that's already invested in order to pay down the debt. Even though COVID-related government relief allows savers to withdraw up to $100,000 from retirement accounts through the end of 2020, penalty-free, you'll still pay income taxes on the amount and miss out on any future potential gains.

Depending on how much you're currently saving in your 401(k), putting it on hold could help you pay down your debt more quickly.

But we humans are complex creatures, and numbers don't tell the whole story. This strategy doesn't consider the power of habits.

Option 2: Pull back on your 401(k) contributions and continue paying down the debt

The second option is to make up some of your lost income by reducing your 401(k) contribution percentage, but not all the way to 0%. 

Your paychecks will be bigger and the extra money can go toward your debt balance while you maintain the smart investing habit you've already started. If your employer offers to match your contributions, that's another reason to keep saving if you can.

One caveat: If you can't make at least the minimum payment on your credit card debt without reducing your 401(k) contributions completely, then stop investing and prioritize your debt. Late fees and penalties will pile up if you don't pay your minimum, and your credit will take a hit.

At its core, being good with money is a commitment to practicing good financial habits. Investing is one.

The average person doesn't have enough cash lying around to make one giant investment and wait until it grows large enough to retire on. The vast majority of people grow their nest eggs slowly, through regular and consistent savings.

If you went cold turkey on your 401(k) right now, it might be difficult to start back up again. Since you've already got that momentum going, do what you can to keep it up.

This article was written by Tanza Loudenback from Business Insider and was legally licensed through the Industry Dive publisher network. Please direct all licensing questions to legal@industrydive.com.

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