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Debt Snowball | Pay 401K Loan or High Interest Loan

by Ryan Yates

Yet another discussion on the order of which debt should be paid off in a Debt SnowBall

Matt Jabs at Debt Free Adventure just wrote a post Debt Reduction vs. Retirement Savings for Bruce and You. Matt discusses the main points involved in making the decission to pay down your debt or invest in your retirement accounts. I agree with all the statements made and the logic behind the article is dead on.

Here’s another question though, what if there is a 401K loan inside of the Debt Snowball?

Background:

Let’s assume that there are 4 types of debts in the snowball

    1) 401K loan $14,000 at 5.25%
    2) Credit Card $18,000 at 8.15%
    3) 2nd Mortgage $23,000 at 12.7%
    4) Personal Loan $20,000 at 3.0%

Following the Dave Ramsey Snow Ball approach, the debts would be paid in the order listed above. Following the the highest to lowest Interest rate approach, the 2nd Mortgage would be first. Followed by the Credit Card then the 401K loan and finally the Personal loan. I want to focus on paying out the least amount of money in interest, but also not ruling out the wealth building potential of the 401K. Now that the economy seems to be turning around a little, this question should be explored.

Let’s take the 401K loan and the 2nd mortgage and breakdown the numbers.
Monthly payments
401K Loan = $421 with a starting 401K account balance of $40,000
2nd Mortgage = $290 with a balance of $23,000
Monthly Snowball fund = $2000 to add to either loan payments

We’ll assume that our efforts begin on Jan 1, 2010. Again, the question is
“Does it make more financial sense to pay a low interest 401K loan first, or a high interest 2nd mortgage?”

Paying the The 2nd Mortgage off first

2nd1st
401k 2nd

Paying the The 401K Loan off first

401k 1st
2nd 2nd

Analysis

Looking at the numbers, I just don’t see a huge advantage to paying the 401K loan off first. After crunching the numbers, $1,136.60 more is paid in interest. Yes, the value of the 401K is $2,395.30 more than if the 2nd mortgage is paid first. After subtracting the extra money paid on the interest the total gain is only $1,258.70. Using these numbers there is not enough difference to push the decision one way or the other.

The 401K growth number was based on the DOW going from 10,000 to 12,500 by the end of year. Translating into the 1.4% growth per month. I even took the trend of the DOW from Jan 2009 until November 2009 and plugged them into the equation. Surprisingly then number didn’t change much. This is definely not what I expected to find.

My Take

If you like the Snowball and enjoy seeing the gains from paying off the debt smallest to largest, then keep doing it and don’t worry about paying a little extra in interest.

If you like paying the highest interest rate first, then continue to do that. The data for this study does not show a clear winner.

Another variable

I took the same data and added in monthly 401K contributions and matches from an employer. This helped to make paying of the 401K look like a better option, but again you could apply that money to the snow ball and get the 2nd mortgage loan paid off quicker too.

If you think the market will come back at a faster rate then 17% for the next year, pay that 401K loan first and try to build some wealth quicker. If you’d like to see a SURE thing and not worry about the markets, pay the 2nd mortgage first and save on the interest.

{ 26 comments… read them below or add one }

Money Funk December 17, 2009 at

Heck, I was going to say pay the Credit Card off first – no reason, just my inner thought talking. I probably think that way because all my stupid cards are raising their rates even though I am a great customer! *blah*

The 401K loan I would leave. I have one, too. Of course mine is only $2K, but the interest is among the lower side. I need to kick the others out before that one.

I do think it would be to your best advantage to pay the 2nd over the 401K – if that is the route you are going. Ready for next year?! I’m ready to kick some whoop ass on this debt. 😉
.-= Money Funk´s last blog ..Personal Loan for Debt Consolidation =-.

Reply

Jeffrey Kosola December 18, 2009 at

You do have a point, the card could be paid off first. If I paid the card off then I would have “Zero” credit card debt. I was kind of surprise by running the numbers though. I’m going to look at switching something around and see what happens. Now that my behavior is changed, its all about getting done FAST and paying as little as possible.

Ka-chiiii (that’s the sound of me opening a can) a can of whoop ass you stated. Let’s make 2010 a great debt free year. That’s for you input Money Funk…

Reply

Matt Jabs December 21, 2009 at

You can’t go wrong getting out of debt. Other than that, everyone’s situation is personal and unique, so all of us must simply do what works best for us.

Personally I am choosing a blended approach. For the most part I am sticking with the debt snowball… with the exception of the fact that I am going to pay off my 2nd mortgage before paying down my student loan – because the rates are so much higher on the 2nd mortgage.
.-= Matt Jabs´s last blog ..Savings Money means Better Buys =-.

Reply

Jeffrey Kosola December 21, 2009 at

I certainly feel the same way about very situtation being unique and personal. Just like there are many ways to get into debt, there are many ways to get out of debt.

In my Debt world, the 2nd mortgage is part of the debt snowball. Anything and everything execept the 1st mortgage I consider in the snowball. I’m still debating whether to go after the LAST credit card at 8.15% or the 2nd mortgage at 12.7%. If I go for the CC then all CC debt is gone faster. If I go for the 2nd mortgage, I save a little in interest. Hmmmm. Choices Choices….

Reply

Matt Jabs December 21, 2009 at

I’m going with 8.8% 2nd mortgage over 6% student loan – they are about the same amounts, although the 2nd mortgage is slightly more. 🙂

I’m excited for that day when I no longer have to think about which debt MY MONEY is going to go toward and instead can think about how should my money work for ME!
.-= Matt Jabs´s last blog ..Savings Money means Better Buys =-.

Reply

Cat December 30, 2009 at

Something I expected to see added to the post, but didn’t is that if you lose or quit your job, the 401K HAS to be paid back in full or you risk major penalties. I know no one thinks they will lose their job, but I would rather make payments to my 401K so I don’t have to worry about that scenario. It may not change a lot of people’s opinion, but it would certainly affect my reasoning. I’m just wondering if you considered the payback requirement as well in your decision making.

Reply

Jeffrey Kosola December 30, 2009 at

That’s a great point Cat. I did think about it, but I was trying to compare the two equally without too many outside influences.

Yes, if you lose your job you have to payback the 401K. If you lose your job you may lose your house. You are still responsible to pay back the 2nd mortgage too, just like all debts.

People can loose their jobs at anytime for almost any reason. I just don’t want to go there life making all my decisions based on that. It sure would be a scary world always have a pending job loss on your brain.

Thanks for the comment, Jeff

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