Advice on debt payback order - 401k loan or CC debt?

mw_2672 · 04-06-2009, 11:08 AM

I am wondering if anyone has advice on how I can apply my finances to debt repayment.

I recently got divorced and my ex-wife dug quite the financial hole from which I am slowly climbing out. I have already been able to pay off almost $10k in debt in the last few months and will have the resources to pay off another $10-15k soon.

Outstanding debts are
Credit Card debt (~10% APR): $27k
401k Loan (~10% APR): $10k
Car Loan (~4% APR): $23k
Mortgage (~5% APR): $380k

My monthly payments are within my comfort zone, so my dilemma is between paying off the 401k loan and the credit cards.

My reasoning behind paying off the 401k first is that while the stock market is at a lower than normal point (I am in my mid-30s, and so am biased strongly towards stock as I am thinking long term) I can invest back the loan amount to get greater gains once the market recovers. Additionally I am hearing the horror stories about credit card companies reducing limits once balances are paid down.

My argument towards paying off the credit card first is the ~$2500 in finance charges that level of balance will cost me per year plus my credit utilization will be reduced, therefore increasing my credit score (which is about 715 right now)

Paying off either will reduce my monthly outgoings by ~$500 a month, which I can more slowly apply towards the CC debt.

Any thoughts on what you might do?

Any responses are much appreciated...

Philip Brewer · 04-06-2009, 12:39 PM

How secure is your job?

I think that's really the key question--because if you lose your job you have 60 days to pay back the 401(k) loan or else you have to declare the unpaid balance as income and pay taxes and penalties.

If your job is secure, I'd go for the credit cards first--any interest you pay to them is gone for good. (Interest that you pay on the 401(k) loan goes into your 401(k), so you end up keeping it.)

If there's any chance that you'll lose your job, I'd get the 401(k) paid off first, simply to remove the potential catastrophe of losing your job and getting hit with the taxes and penalties at the same time.

The mix of investments in your 401(k) ought to be a separate question. Unless the available choices are very limited indeed, you ought to be able to get some diversity out of stocks simply by shifting the investments in the 401(k). That's either the right thing to do or it isn't (depending on your own financial situation--in particular what other assets you own) and shouldn't really affect your payback decision.

Stephen Dress · 04-06-2009, 04:07 PM

Is getting out of debt as fast as possible your goal?

If the answer is "yes", then the order you pay off your debt is simple.

The fastest way to pay off your debt is to attack the one debt first that will free up the most cash flow once paid off.

Do the following exercise:

1. Write all your debts down the left hand side of a piece of paper, then make two columns. In one column enter the balance owed, and the other enter the monthly payment.
2. Divide the monthly payment by the balance owed. You will get a number with a decimal in front of it. (ie Balance owed $10,000, monthly payment $500, then $500/$10,000=0.05)
3. Move the decimal point over two spaces to the right, and write this number down. (0.05 = 5.00)
4. Do this for all of your debts, the debt that results in the highest number from step 3 is the one you should attack first.

By doing this excercise, you will free up the most cash flow for the least amount of balance owed. In other words, you get the most bang for your buck. Once this debt is paid off, use the cash flow you just freed up and pay down the debt with the next higher number from step 3, and so on down the line. The result is you pay off your debt in the most timely manner possible.

Notice I made no mention of interest rate. When it comes to paying down debt, the key is to pay down the debt that will free up the most cash flow, not the one with the highest interest rate. (exception: if any of your debts are at 0% interest, that is free money, no need to include it in your exercise above)

the weakonomist · 04-06-2009, 06:49 PM

I agree with Brewer, losing your job makes that 401(k) loan a pain point. With that in mind I'd recommend paying that off just in case. It's great that you are focused on paying off your debt, keep it up!

mw_2672 · 04-07-2009, 04:49 AM

@Stephen Getting out of debt as fast as possible is not necessarily my goal - I want to maximize long term gain, which is why I am gambling between the 10% yearly yield on my 401k (funded by myself of course) and the potential gains if the stock market rallies.
@weakonomist, @philip Good analysis. While I feel my job is secure, in todays environment it is very hard to say that with certainty.

Even though there is some risk, I am strongly leaning towards paying off the 401k first and using the freed up monthly payment to accelerate the cc payment.

Thanks for the replies.

darryl · 06-17-2009, 03:23 AM

Quote:

Originally Posted by Philip Brewer

How secure is your job?

I think that's really the key question--because if you lose your job you have 60 days to pay back the 401(k) loan or else you have to declare the unpaid balance as income and pay taxes and penalties.

If your job is secure, I'd go for the credit cards first--any interest you pay to them is gone for good. (Interest that you pay on the 401(k) loan goes into your 401(k), so you end up keeping it.)

If there's any chance that you'll lose your job, I'd get the 401(k) paid off first, simply to remove the potential catastrophe of losing your job and getting hit with the taxes and penalties at the same time.

The mix of investments in your 401(k) ought to be a separate question. Unless the available choices are very limited indeed, you ought to be able to get some diversity out of stocks simply by shifting the investments in the 401(k). That's either the right thing to do or it isn't (depending on your own financial situation--in particular what other assets you own) and shouldn't really affect your payback decision.

I certainly agree with Philip..I also think so..Keep it up..!!

Good Luck.!!

mw_2672 · 06-17-2009, 05:09 AM

Thanks. In the end I had more finances than expected due to bonuses and an employee stockplan. Given the turbulent state of employment at my company, I decided to pay of the 401k loan in full just in case, and then apply the remaining $10k to my credit card.

With the extra money I have each month I have slightly increased my 401k contribution and also my credit card payoff rate.

Thanks for the advice all.

04-06-2009, 11:08 AM	#1
mw_2672 Junior Member Join Date: Apr 2009 Posts: 3 Thanks: 0 Thanked 0 Times in 0 Posts Reputation: (10)	Advice on debt payback order - 401k loan or CC debt? I am wondering if anyone has advice on how I can apply my finances to debt repayment. I recently got divorced and my ex-wife dug quite the financial hole from which I am slowly climbing out. I have already been able to pay off almost $10k in debt in the last few months and will have the resources to pay off another $10-15k soon. Outstanding debts are Credit Card debt (~10% APR): $27k 401k Loan (~10% APR): $10k Car Loan (~4% APR): $23k Mortgage (~5% APR): $380k My monthly payments are within my comfort zone, so my dilemma is between paying off the 401k loan and the credit cards. My reasoning behind paying off the 401k first is that while the stock market is at a lower than normal point (I am in my mid-30s, and so am biased strongly towards stock as I am thinking long term) I can invest back the loan amount to get greater gains once the market recovers. Additionally I am hearing the horror stories about credit card companies reducing limits once balances are paid down. My argument towards paying off the credit card first is the ~$2500 in finance charges that level of balance will cost me per year plus my credit utilization will be reduced, therefore increasing my credit score (which is about 715 right now) Paying off either will reduce my monthly outgoings by ~$500 a month, which I can more slowly apply towards the CC debt. Any thoughts on what you might do? Any responses are much appreciated... Last edited by mw_2672; 04-06-2009 at 11:51 AM.

04-06-2009, 04:07 PM	#3
Stephen Dress Junior Member Join Date: Apr 2009 Posts: 7 Thanks: 0 Thanked 0 Times in 0 Posts Reputation: (10)	Is getting out of debt as fast as possible your goal? If the answer is "yes", then the order you pay off your debt is simple. The fastest way to pay off your debt is to attack the one debt first that will free up the most cash flow once paid off. Do the following exercise: 1. Write all your debts down the left hand side of a piece of paper, then make two columns. In one column enter the balance owed, and the other enter the monthly payment. 2. Divide the monthly payment by the balance owed. You will get a number with a decimal in front of it. (ie Balance owed $10,000, monthly payment $500, then $500/$10,000=0.05) 3. Move the decimal point over two spaces to the right, and write this number down. (0.05 = 5.00) 4. Do this for all of your debts, the debt that results in the highest number from step 3 is the one you should attack first. By doing this excercise, you will free up the most cash flow for the least amount of balance owed. In other words, you get the most bang for your buck. Once this debt is paid off, use the cash flow you just freed up and pay down the debt with the next higher number from step 3, and so on down the line. The result is you pay off your debt in the most timely manner possible. Notice I made no mention of interest rate. When it comes to paying down debt, the key is to pay down the debt that will free up the most cash flow, not the one with the highest interest rate. (exception: if any of your debts are at 0% interest, that is free money, no need to include it in your exercise above) __________________ Be Forever Debt Free - Make It Your Reality WiseDebtor.com

04-06-2009, 06:49 PM	#4
the weakonomist Member Join Date: Feb 2009 Location: Southeast Posts: 64 Thanks: 0 Thanked 0 Times in 0 Posts Reputation: (10)	I agree with Brewer, losing your job makes that 401(k) loan a pain point. With that in mind I'd recommend paying that off just in case. It's great that you are focused on paying off your debt, keep it up! __________________ Weakonomics.com Twitter.com/the_weakonomist

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04-06-2009, 12:39 PM	#2
Philip Brewer Wise Bread Blogger Join Date: Jul 2007 Location: Champaign, IL Posts: 182 Thanks: 1 Thanked 6 Times in 4 Posts Reputation: (27)	How secure is your job? I think that's really the key question--because if you lose your job you have 60 days to pay back the 401(k) loan or else you have to declare the unpaid balance as income and pay taxes and penalties. If your job is secure, I'd go for the credit cards first--any interest you pay to them is gone for good. (Interest that you pay on the 401(k) loan goes into your 401(k), so you end up keeping it.) If there's any chance that you'll lose your job, I'd get the 401(k) paid off first, simply to remove the potential catastrophe of losing your job and getting hit with the taxes and penalties at the same time. The mix of investments in your 401(k) ought to be a separate question. Unless the available choices are very limited indeed, you ought to be able to get some diversity out of stocks simply by shifting the investments in the 401(k). That's either the right thing to do or it isn't (depending on your own financial situation--in particular what other assets you own) and shouldn't really affect your payback decision.

04-07-2009, 04:49 AM	#5
mw_2672 Junior Member Join Date: Apr 2009 Posts: 3 Thanks: 0 Thanked 0 Times in 0 Posts Reputation: (10)	@Stephen Getting out of debt as fast as possible is not necessarily my goal - I want to maximize long term gain, which is why I am gambling between the 10% yearly yield on my 401k (funded by myself of course) and the potential gains if the stock market rallies. @weakonomist, @philip Good analysis. While I feel my job is secure, in todays environment it is very hard to say that with certainty. Even though there is some risk, I am strongly leaning towards paying off the 401k first and using the freed up monthly payment to accelerate the cc payment. Thanks for the replies.

06-17-2009, 05:09 AM	#7
mw_2672 Junior Member Join Date: Apr 2009 Posts: 3 Thanks: 0 Thanked 0 Times in 0 Posts Reputation: (10)	Thanks. In the end I had more finances than expected due to bonuses and an employee stockplan. Given the turbulent state of employment at my company, I decided to pay of the 401k loan in full just in case, and then apply the remaining $10k to my credit card. With the extra money I have each month I have slightly increased my 401k contribution and also my credit card payoff rate. Thanks for the advice all.