One question that is regularly asked by clients is whether they should invest in their company’s retirement plan or pay off high interest loans, such as credit card debt. To answer, you must evaluate your rate of return on your cash outlay.
Are you giving up free money?
Many companies offer 401(k) or similar retirement plans to their employees, and an employer match might be available. If that’s the case, you should contribute to the plan at least enough to get the full match.
Example 1: Melissa North earns $80,000 a year. Her company’s 401(k) plan offers a full match for up to 6% of salary. Therefore, Melissa should contribute at least $4,800 (6% of $80,000) to her 401(k) account this year, which will entitle her to a $4,800 company match.
Whether you’re offered a full or partial match, you should contribute at least enough to get all the dollars your company offers. Failing to get the maximum match means you’re giving up free money.
Paying down credit card debt
Getting your employer match is a no-risk way to earn a 100% return (or a lesser return, with a partial match) on your money. If that’s often someone’s best investment move, paying down credit card debt may be next best. When you reduce a credit card balance and the interest you’re paying, you’re effectively earning the credit card interest rate.
Example 2: Owen Palmer has a credit card that charges 12% on unpaid balances. When Owen prepays $1,000 of his balance, he saves $120 (12% of $1,000) in interest that year. That’s a 12% return on his outlay. What’s more, credit card interest typically is not tax deductible. Thus, Owen earns 12%, after tax, by prepaying his loan.
It’s possible that Owen could receive a higher return by doing something else with his $1,000, but that probably would mean taking substantial risk. Prepaying debt, conversely, has no investment risk beyond forgoing the chance for a higher return. In today’s low-yield environment, prepaying debt can be appealing.
Evaluating education loans
Prepaying credit card debt may be attractive for many people, but prepaying student loans can be a tougher call. Interest rates may be lower than on credit card debt, so the benefit of prepaying is not as great. What’s more, up to $2,500 of interest on student loan debt is tax deductible each year. To get the maximum deduction, your modified adjusted gross income (MAGI) can be no more than $65,000, or $130,000 on a joint return. Partial deductions are allowed with MAGI up to $80,000 or $160,000.
If interest is tax deductible, the benefit of prepaying the loan is reduced.
Example 3: Rita Simmons has outstanding student loans with a 7% interest rate. This year, she expects to fall in the 25% federal tax bracket, so paying the interest actually saves her 1.75% (25% of 7%) in tax. Thus, Rita’s net interest rate cost for her student loans is 5.25%: the 7% she pays minus the 1.75% she saves in tax.
In her situation, Rita would earn 5.25%, after tax, by prepaying her student loans. That could be a good move, for an outlay without investment risk, but it’s also possible that Rita could earn more by investing elsewhere. Moreover, Rita would have to relinquish liquid assets by prepaying, and replacing those assets in case of an emergency might not be simple.
Money from home
Prepaying a home mortgage may be even less beneficial than prepaying student loans. Assuming a 4% interest rate and a 25% tax rate, the after tax benefit of prepaying would be only 3%. Although virtually all homeowners can deduct mortgage interest, the net payoff is even smaller for taxpayers with tax rates higher than 25%.
The Bottom Line
Prepaying a loan makes the most financial sense with high interest rates and low tax benefits. State income tax also should be considered. Our office can help you calculate the true return of debt prepayments, so you can make informed decisions.