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?
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.
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
Paying the The 401K Loan off first
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.
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.
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.