Cut Debt Or Build Wealth

Posted on December 29, 2007
Filed Under Advice, Debt Consolidation, rates | Leave a Comment

Cutting big balances on high-interest debt is a key part of sound financial planning. So is building up your assets. But if you can afford to do only one, which should you choose?

The answer depends largely on the size of your debt, the interest you pay on it as well as the growth you expect on your investments.

Say you’re about to get a pay raise.

If you expect such an increase and you’re not already maximizing retirement plan contributions, you can make a larger commitment. The top 401(k) contribution in 2008 will be the same as in 2007: $15,500.

Workers who will be 50 or older in 2008 can add up to $5,000 more.

“You won’t feel deprived,” said Mark Johannessen, a managing director of Harris Private Bank in McLean, Va. If you hold your personal and household spending at this year’s level, you won’t miss extra money that you contribute to a tax-advantaged retirement plan.

But is the money better spent paying down debt that charges interest?

“If you continue to roll over a balance, credit cards are taking money out of your pocket,” Johannessen said. You’ll pay interest at high rates. And you won’t get a tax deduction for credit card interest.

To decide how to use extra pay in 2008, compare the pros and cons of each strategy.

One of the main benefits in a 401(k) plan is a company match. Of all plans, 88% offer some sort of matching contribution, according to Hewitt Associates. (NYSE:HEW)

“You should contribute at least enough to your 401(k) to get a full employer match,” Johannessen said.

If you don’t take the full match, you’re giving away money. It’s like saying no to a pay raise.

Suppose a John Smith will have a base salary of $100,000 in 2008. His employer has a 401(k) plan.

Free Money

The company match is 50% of the first 6% of pay. That is typical for a 401(k).

If Smith kicks in 6% of his salary, that’s $6,000. Then the company will add a 50% match: $3,000.

So Smith should contribute at least $6,000 next year. But should he contribute more if he also has credit card debt?

“That depends on the credit card interest rate,” Johannessen said.

The higher the rate, the more it makes sense to pay down the balance. All the more so the larger the balance and the bigger the percentage of your disposable income it comes to.

Suppose Smith has a balance on a credit card where the interest rate is 12%. That’s in line with national averages.

Paying down the balance is equal to getting a 12% return on his outlay. It’s equal to a 12% after-tax return because credit card interest is not tax-deductible.

And it’s equal to a 12% after-tax return, risk-free. There is no investment risk to paying down a credit card balance.

In contrast, there’s no guarantee that Smith can earn 12% by investing in his 401(k) — let alone 12% after tax, risk free. So he should pay down his credit card.

Let’s look at a different scenario. It applies to a Jane Jones. Instead of a credit card, she has run up a balance on a home equity line of credit.

The trade-off she faces would be different.

She pays an interest rate of 7%. That’s around the rate most people are paying for home equity debt.

But interest is tax-deductible. That’s true for home equity debt up to $100,000.

Suppose Jones is in a 30% tax bracket. That would include federal and state income tax.

With a 7% home equity line of credit, her after-tax rate would be 4.9%.

You can calculate that by subtracting her 30% tax rate from 100%. Take the 70% remainder and multiply it by her 7% interest rate. The 4.9% result is her after-tax rate.

Jones is confident she can earn more than 4.9%, after tax, by investing in her 401(k). So she’ll use her pay raise to do that instead of paying down her balance on the line of credit.

Her home equity debt, at 4.9% after tax, in effect is a cost she pays to fund her retirement account.

Long term, that will be a good move if her 401(k) delivers after-tax returns greater than 4.9%.

She stands a good chance of having that happen.

In the decade ended Nov. 30, U.S. diversified stock funds averaged an annual return of 6.92%, according to Morningstar.

Returns are higher over longer periods, which allow time for rebounding from setbacks like the 2000-02 bear market.

Debit Card

As for Smith, once he pays off his credit card debt he can increase his 401(k) contributions. And he can focus on avoiding high-rate balances in the future.

He might consider switching to a debit card, Johannessen says. Purchases will come out of his bank account and he can keep away from expensive debt.

Whether you use a credit or debit card, pay attention to the monthly statements you receive.

They offer a record of your purchasing patterns, which will help you to set a budget in 2008.

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