Comparing Options

After I pay my bills each month and allocate budgeted dollars for groceries and gas, I'm lucky to have $50 leftover for debt repayment or savings.  About $400/month goes into my 401k, and it is currently valued around $40,000.  I'm 29, married (stay at home spouse), and have a 15 month old daughter. 

We really want to get out of debt quickly, I estimate that my regular monthly payments, plus a booster payment of $400/month will pay it all off in 2 years.  After that, we want to own at least 75% of our home in 10 years (we have a 30 year mortgage).

Amy

We will all face questions similar to Amy's. And sometimes it seems like we're trying to compare apples to oranges. It's hard to even know where to begin.

On a basic level, she's right that the first step to a good financial future is getting out of debt. Even if that means delaying saving for retirement. Paying interest on borrowed money will make it harder to accumulate assets.

That's not to say that she shouldn't save any money for retirement until all of her debts are paid. But paying off high rate credit cards should be a priority.

There is some risk to paying off debts first. Some people are perpetually in credit card debt. And if they wait to save for retirement they might never get started. But Amy appears to have the necessary discipline to pull it off.

A second way to look at the question is mathematically. Often that's the best tactic. The trick is finding a way to compare the different options that you're considering.

In this case Amy is really asking about her net worth three years from now. Remember that increasing assets or reducing debts improves your net worth.

She can use one of the calculators that are available to determine what will happen to the two accounts under different circumstances. One of my favorites is at Bankrate.com . Her goal is to figure out what the amount due on her credit card and what her 401k balance will be in 3 years.

Amy will be creating two different scenarios. In one she'll stop contributing to the 401k and use $400 to pay off debts. In the other, she'll continue to contribute to her retirement and only pay off $50 per month.

Try to make the comparison as neutral as possible. The assumptions that you make in creating the examples can predetermine the outcome. Especially in longer time periods.

To really do it right, she should take the balances under each scenario and calculate what her net worth would be. If that's too complicated, then simply compare the amount of debt paid off vs. the amount her 401k would increase.

Even if she doesn't have access to a computer a simple comparison can be created using a calculator. To estimate how much debt is to be paid off she'll need to create a list with 4 columns. The first column is for the beginning credit card balance. To that she'll add the second column which shows the amount of interest owed for that month. She can calculate that from the amount owed multiplied by the annual interest rate being charged divided by 12.

From that total she'll subtract column three which is the amount of the payment for the month. The result is column 4 - the ending balance. Which naturally is the beginning balance for the next month.

A second table can be created for the 401k plan. The first column is for the beginning balance. To that will be added the second column (investment earnings) and the third column (new contributions). The total will be the ending balance in column 4. And, once again, the ending balance from one month will be the beginning balance of the following month.

Don't forget to include any employer matching contributions. They can make a big difference in your account growth. She can compare the results to see which would work better for her.

One other thing for Amy to consider. Both of her choices are good. One might be slightly better than the other. But either one is better than doing nothing. Doing nothing is the worst choice that she could make.