Whenever you find an extra dollar or two, knowing what to do with it can make you richer. So which would you do - add it your retirement account, or pay off the plastic?
According to the most recent release from the Federal Reserve, credit card debt in the U.S. now stands at $864 billion dollars, or an average of $7,226 per household. Average interest rate on accounts paying interest was just under 13 percent according to the Federal Reserve, although other surveys, like Bankrate.com’s, put average rates closer to 14.5 percent.
If you live in a household struggling to pay off high interest debt, you know how important it is to reduce those balances. But you also know it’s not the only priority you have. For example, saving for retirement is also a critical goal. So when you find yourself with an extra dollar or two, where should it go – to reduce debt, or increase retirement savings?
That’s a question we recently got when we took our camera to the streets to talk to people about their money concerns. Check out the answer in the video below, then read on for details…
Deciding what to pay first
Whatever your goals, you obviously want to get the biggest bang for your investment buck. Compared to the rate of return on a typical savings account, CD, or stock investment, you’ll have a higher rate of return by paying off your credit cards first.
It’s useful to use a credit card calculator, like this one from the Federal Reserve, to see what can happen when you pay extra on a credit card balance. For example, plug in the average balance of $7,000 and the average interest rate of 13 percent, and you’ll find that by paying only the 2 percent minimum monthly payment, it will take 24 years to pay off the card, and cost more than $7,500 in interest.
But instead of paying the minimum 2 percent payment ($140 a month to start), suppose you jacked the payment up to $300 every month. You’ll pay the card off in two years and pay $1,100 in interest. You’ll keep $6,400 that otherwise would have gone to the bank.
As Stacy said in the video, paying off a high interest debt is like earning that interest, risk-free and tax-free: tough to beat. So the rule is to pay off that kind of debt as soon as soon as possible. But as with most rules, there’s an exception.
Many 401(k)s and other types of retirement plans offer a company match. In these plans, your employer matches your contributions up to a certain amount, typically 50 percent of whatever you contribute, capped at 6 percent of your annual salary. So if you earn $50,000 annually and contribute $3,000 (6 percent) to your retirement plan, the company will contribute $1,500.
That’s like earning a risk-free return on your investment of 50 percent.
So if your company matches your 401(k) contributions, make sure you’re contributing enough to get every free penny being offered by your plan. After that, put any extra income you have left into paying off your debt. Once your debt is wiped out, then you can start contributing more to your 401(k) – or looking into other investment options.
Getting it done
Now that you know what to pay and when, you’ll need to come up with the cash.
Talk to your HR department, find out what your company matches in 401(k) or retirement contributions, and set your paycheck to automatically withdraw that amount. Since the money is coming out before you see it, that’s one less thing you’ll have to worry about.
Then follow these steps to find the money to pay off those credit cards:
- Create a simple budget. And don’t let the word “budget” freak you out. All it means is keeping track of the money you have coming in and going out. There are apps and websites that can help you do it almost automatically and plenty of how-to articles that can help.
- When you start looking at where your money’s going, you’ll see how much you have left over to invest, as well as ways you might find more. Take that money and add it to your credit card payment. Stay motivated by plugging your new payments into the credit card calculator to see how much faster you’ll be debt-free and how much richer you’ll be by reducing the interest you’ll pay.
- Not finding extra money in your budget? There are loads of ways you can save without sacrificing your quality of life, from cutting the cable to raising insurance deductibles. Check out 25 Simple Ways to Save an Extra $1,000 for more ideas.
- When you’ve paid your debts and maxed your retirement accounts, look into other types of investments to help your savings grow more rapidly. You might use your extra money to invest in stocks, or maybe you’ll find a great rate on a CD. For ideas check out 4 Ways to Invest Without Much Money.