We frequently hear that it is wise to pay off debt as soon as possible. Unfortunately, sometimes we act on that statement before asking ourselves these important questions…
1. What type of debt do I have (credit card, mortgage, auto)?
2. What are the rates on the debt (fixed, variable, low-high)?
3. What assets (cash, 401K/IRAs) do I have and what is the return (5%, 10% or More)?
It’s Sorta Like Dieting the Right Way
You can try to lose weight by just eating less fattening foods or you can really think about your sleeping, eating, exercise habits and all of the other factors that registered dietitians such as skinnyandthecity say you should think about.
So where does that leave us? Well, let’s take a look at the major types of debt we have as well as our 401Ks.
Credit Card Debt is Generally Not Good
Yep, its true, credit card debt is generally a place you do not want to be. But, before you decide to pay off one credit card, make sure you compare it with the interest rates & balances of your other cards. Generally, you want to pay off the debt of credit card balances with the highest APR first and then move to the lower APR cards. Also, sometimes, you can transfer a high APR credit card balance into a Lower APR card. Make sure you review all of the terms because the credit card companies generally charge a transfer fee, sometimes 3%. Oh, one last thing, you do NOT get any tax benefit for paying interest on your credit card. Mortgage interest on the other hand, is tax deductible.
Mortgages Can Be Bearable
Of course you never want to make another monthly mortgage payment again. We all want to be in that boat. But, that’s a debt you may have to live with for awhile. On the bright side, you do get a tax deduction from Uncle Sam for paying the mortgage interest. If you are still considering paying off your mortgage, be sure to review your mortgage rate, principal & ability to refinance at an attractive rate.
Should I Really Be Contributing to my 401K when I have Debt?
Believe it or not, there are people out there that still contribute to their 401K when they have $40K in credit card debt. In some cases, it may make sense, if you have a great matching program (100%) with your employer or you are getting a fantastic return, but generally it’s not the right route to take. Remember, you have to be earning at least a 20% return (after tax) annually on your 401K to even consider not pay off credit card debt (~15%). Think this through.
There Are Still Other Factors
You may also want to factor in your financial goals, career path, and personal situation among others to make a sound financial decision. You definitely do not want to rush into this.
