Should You Focus on Your 401(k) or Erase Credit Card Debt First?

Many Americans are in a tight spot: Average credit card debt has topped $7,300, and nearly two-thirds say it’s delaying major life decisions. One option is to prioritize paying off that debt over 401(k) contributions. But skipping 401(k) contributions means missing out on long-term growth and, for many, ‘free’ money from their employers.

So should you pay off credit card debt first or invest for the future? Below, we explain the tradeoffs and help you choose a strategy that fits your situation.

Understanding the Dilemma

Credit card interest can eat away at your finances, but stopping retirement contributions means missing out on compounding growth and, for many, employer matching contributions. The “right” answer depends on whether your employer does match your contributions, and, to a lesser degree, your age and amount of credit card debt.

For someone in their 20s, the power of compounding in a retirement account is enormous. But so is the cost of indefinitely carrying high-interest debt, particularly for outsized debt. Making the right call means looking closely at the numbers.

An ‘Average’ Scenario

To approach the problem, let’s make the following assumptions, based roughly on national and historical averages:

• Credit card debt: $7,500
• Credit card interest rate: 20%
• Annual salary: $60,000
• Employee 401(k) contribution: 5% of salary
• Employer 401(k) contribution: 5% of salary
• 401(k) annual return: 6.5%
• Additional credit card spending: None

When It Makes Most Sense to Focus on Your 401(k)

In most cases, maintaining retirement contributions makes more long-term financial sense if your employer is matching all or part of your contribution. And the younger you are, the more compelling the argument for prioritizing your 401(k).

Consider this: In the scenario above, the employer match alone would be $3,000 a year, which dwarfs the roughly $1,700 in annual interest you’d pay on the $7,500 in credit card debt. And that’s before considering the compounded annual returns and any tax benefits from the contribution. If you redirected $250 a month from your 401(k) to your credit card, thereby losing the $250 employer match, it would cost you roughly $110,000 in compounded gains in your 401(k) over 30 years.

When Your Employer Doesn’t Match

On the surface, the choice looks different if your employer isn’t matching any of your 401(k) contribution. In that case, you’d be paying 20% interest on the $7,500 in credit card debt, versus gaining 6.5% a year on any money you put in your 401(k). Simple, right?

Not exactly. Again, that doesn’t take compounding into account. Let’s consider:

• You divert $3,000 a year from your 401(k) to your credit card
• At that rate, you pay off $7,500 in about 42 months at a total cost of about $10,500.
• Alternatively, if you pay your credit card minimum each month (interest plus 1% of principal, or $25 a month, whichever is greater), you could pay it off in about 17 years at a total cost of about $18,000.
• But at 6.5%, the $10,500 you spent paying off the credit card would be worth about $28,000 after 17 years if you had made contributions to your 401(k) instead.)
• After 30 years, that $10,500 would be worth about $69,000.

Credit card interest can be brutal. It’s always a good idea to pay off the balance. But not necessarily by diverting money from your retirement account. It’s better to look for almost any other way to do so first. Of course, the closer you are to retirement, and the fewer years of compounding ahead of you, the more it might make sense to divert some 401(k) contributions—again, assuming you’re not getting an employer match.

Balancing Priorities

Another option is to split the difference, diverting half of your normal 401(k) contribution to paying off the credit card. The math still holds—over the long term, it’s probably better to put all of the money into your retirement account.

Bottom Line

Paying off your credit card can offer peace of mind, improve your credit score, and free up cash later for additional saving and investing. If the debt feels like a dark cloud hanging over your finances, eliminating it can bring emotional as well as financial relief. But think carefully and crunch the numbers before you decide to divert money from your retirement account.