How to Decide Whether to Add to Your 401(k) or Pay Off Your Debt

Most of us don't have unlimited money. So sometimes, you have to make hard choices about what to do with your cash. 

If you're focused on debt relief, it may seem like paying your creditors is the only thing you should be doing. But that's not always the case. Sometimes it’s more profitable to pay off your debt, and sometimes it’s better to add money to your 401(k). 

Here's how to choose. 

Consider the Interest Rate on Your Debt

When you're deciding whether to pay off debt or put money into your 401(k), first consider the interest you're paying on the debt. Interest is the cost of borrowing—the higher your rate, the more expensive the loan. 

When you pay off debt early, your return on investment is the saved interest. If your interest rate is 10% per year, paying off your debt essentially gives you that interest amount as ROI. If your interest rate is even higher at, say 27% or above like that of many credit cards, paying off the debt saves a whole lot of interest. Paying a high rate on credit cards is one reason many people are eager for credit card debt relief. 

If you have very high-interest debt, such as payday loans with rates that could be upwards of 400% per year, it's even easier to see that you'd likely get more return from paying off that debt than pretty much any other investment.

If you have debt at a low rate, such as a mortgage loan at 4%, you'd likely want to put money into a 401(k) instead of repaying that loan early. That’s because long-term investments historically earn a 7% to 12% return—even though there’s no guarantee you’ll get those returns. That's a much higher ROI than you get from paying off a 4% loan.

Check Your Employer's 401(K) Match

In some cases, the interest rate on your debt is neither so low nor so high that there's a clear answer about whether to repay debt or invest in a 401(k). The tie-breaker here should be whether your employer offers matching benefits for your 401(k) plan. 

Some employers will match your 401(k) contributions up to a limit, putting money into your account when you put money into the account. It will usually be a percentage of your match, commonly 50% though some will go as high as 100% matches—to a point. Generally, employers cap how much they match, such as matching your contributions up to 4% or 6% of your salary.

That matching money is essentially a risk-free investment (though some employers require you to stay with the company a certain amount of time to keep matched funds). If you get a 100% match, that's like getting a 100% return on your own investment. And that's before you get your money into the market and earn potential returns. Most of the time, you won’t want to pass up an employer match.

For this reason, unless you have very high-interest debt, it often makes sense to pay the minimums on your debt (depending on your loan interest rate and whether becoming debt-free is a major priority). Then you could max out your 401(k) match before paying off more debt or putting more money into your 401(k). 

Think About How Close You Are to Retirement 

Consider how close you are to retirement when you decide whether to invest or pay down debt. If you don't have money in a 401(k) or other retirement plan, you may not be able to retire, or you may struggle to cover the basics. Most people don't have pensions. And Social Security benefits replace around 40% of pre-retirement income. That isn't generally enough to live comfortably. 

If you wait to start investing, you lose that time to let your money grow. Compounding happens when your returns are reinvested, helping your money grow even faster. As a result, waiting makes it much harder to end up with a nest egg large enough to support you. 

If retirement is approaching and you don't have much saved, prioritizing 401(k) contributions could make the most sense.

There are ways to deal with debt, including negotiating a payoff plan with creditors, or working with a debt settlement company to potentially pay less than you owe. But there aren’t easy ways to deal with potential post-retirement issues such as being sick or unable to work and having only Social Security income. It’s also worth noting that 401(k) money is usually protected in bankruptcy or if a creditor sues you, so this could be a safer source of funds. 

Weigh these three big factors to help you decide whether to pay off your debt or invest. The right choice depends on your specifics, but often, putting at least some money in a 401(k) can be worthwhile, even during a debt payoff journey.