Five Questions to Help You Make Better Financial Decisions

There is simple math behind figuring out how to juggle multiple important goals

So you got a raise. Should you put the money in your 401(k)? Or would you be better off paying down your credit-card balance, prepaying your mortgage or doing some of each?

Most people juggle multiple important financial goals. Figuring out how to prioritize among them can feel like a complex puzzle with no right or wrong answer.

But from a mathematical perspective, there is a clear-cut and relatively simple way to help you earn higher guaranteed returns and maximize long-term wealth.

It is a method many people fail to use, according to new research Vanguard Group released this week. The money manager linked customers’ 401(k) and brokerage account data to their credit-bureau records to see how they allocate their money between savings and debt.

Some fail to make ideal choices due to a lack of knowledge or financial constraints. Others opt to do what feels right based on their emotional needs, such as a desire for peace of mind, without considering the impact on their future wealth.

The mathematically correct answer isn’t the right one for everyone, or every situation. But it gives you a framework to consider the pros and cons of, say, giving priority to a good night’s sleep over the highest possible return.

“These are deeply personal decisions,” said Andy Reed, head of behavioral economics research at Vanguard and co-author of the research.

“We are not telling people they are right or wrong to make the decisions they’ve made,” Reed said. 

Let’s walk through some questions to help you think mathematically about maximizing returns, even if you still choose to trust your gut at the end of the day. After you answer each question, we will explain the math, and you can compare your choices to those of Vanguard’s customers.

1 OF 5

Your 401(k) plan offers a dollar-for-dollar match on the first 3% of pay you contribute. You also have a $10,000 credit card balance accruing interest at 22% annually. You owe $5,000 on a car loan that charges 12% and $50,000 on student loans at 7%. Which provides the best financial return?

1. Prepaying credit card balance
2. Prepaying car loan
3. Prepaying student loan
4. Saving enough in 401(k) to get the match

The four choices in this question are easy to compare because they all come with guaranteed returns.

The return on prepaying debt is the interest rate you’ll save yourself from having to pay. That’s 22% in the case of the credit card debt.

While a guaranteed 22% return is pretty good, it’s far below the 100% return you would earn by contributing enough to the 401(k) account to secure your employer’s dollar-for-dollar match. That immediately doubles your balance, translating to a 100% return.

At least in theory, “people should look across their balance sheet at where they can get the highest guaranteed returns, and redirect their next dollar of cash flow to that,” said Reed.

Practical considerations may dictate doing something aside from what the math says is optimal. While a comparison of the returns alone might persuade you to skip paying your credit card bill to get the full 401(k) match, doing so could cause your debt to spiral beyond your ability to pay it. That could damage your credit score.

“We would never say to go so far as to not pay down your credit card,” Reed said.

Likewise, many sacrifice returns to build emergency funds—something most financial advisers highly recommend to prevent the use of credit cards for unexpected expenses.

There is a danger of relying too much on any single approach–-mathematical or emotional–-to make these decisions, said Reed.

Among workers in 401(k) plans Vanguard administers who are prepaying installment debt, 30% weren’t contributing enough to their 401(k) to get a full match.

On average, people who did this gave up almost $1,100 a year in matching funds. Vanguard estimates that a 30-year-old person with median income who repeats that same $1,100 decision for the next decade could wind up with about $120,000 less in the 401(k) at age 65.

2 OF 5

Now you have to figure out whether to save more in your 401(k) beyond the match or use your excess cash to pay down debt. What should you prioritize?

1. Saving more in 401(k)
2. Prepaying car loan at the 12% rate
3. Prepaying credit card balance at the 22% rate
4. Prepaying student loan at the 7% rate

After securing your full match, your return on any additional 401(k) contributions depends solely on what you earn in the markets. Assuming you have a portfolio with 70% in stocks and 30% in bonds, your expected annual return would be around 5.5%, according to Vanguard’s forecasts, although your actual return could be higher or lower.  

In contrast, by prepaying your $10,000 credit card balance, you can secure a guaranteed 22% return. That also far exceeds the 12% you would get by prepaying your car loan and the 7% you would earn by prepaying your student loan.

Over half of participants in Vanguard-administered 401(k) plans hold credit card debt. Six in 10 of them contribute more to their 401(k) than the amount needed to get a full match. On average, they contribute $3,900 above the match level, which is money those with credit card debt could use instead to pay it down.

Among Vanguard customers with credit card debt, 30% are prepaying loans with lower interest rates, such as student loans or a mortgage. Those prepayments amount to $3,500 a year, or almost enough to wipe out the average credit card balance of $5,000.

3 OF 5

You want to pay off the credit card debt, but your money is tied up in your 401(k). So you are considering borrowing $10,000 from your retirement account to pay off the credit cards. The rate on your 401(k) loan is 8%. Should you do this?

1. Yes
2. No

From a mathematical perspective, you would come out ahead with a 401(k) loan.

The 8% interest rate is far below the 22% rate you are paying on your credit card balance. By using the 401(k) loan to pay off your credit cards, you would immediately lock in a guaranteed 14% return.

In addition, you will repay the 8% interest rate on your 401(k) loan to yourself over time, typically over up to five years.

The big risk you should weigh is whether you might leave your current employer while the loan is outstanding.

Many 401(k) plans require borrowers to repay their remaining balance within 30 to 90 days of leaving the payroll, or face default. Someone in default must pay income tax on their remaining loan balance, plus a 10% penalty if under age 59½.

About 75% of Vanguard 401(k) participants with credit card debt are eligible for a 401(k) loan but haven’t used one.  Most 401(k) plans offer employees the option to borrow up to half their balance, or $50,000, whichever is less.

4 OF 5

You have paid off your credit card debt. Now, you inherit money and buy a house. You have a $500,000 30-year mortgage that charges a 6% interest rate. You are 50 years old and want to pay off your mortgage by the time you retire. What should you do with any extra income?

1. Save more than the match in your 401(k)
2. Prepay your auto loan at the 12% rate
3. Prepay your student loan at the 7% rate
4. Prepay your mortgage at the 6% rate

By prepaying your auto loan, you will lock in a guaranteed 12% return. That’s far higher than the 7% return on your student loan or the 6% return you would get by prepaying your mortgage.

You might earn more than 12% on your 401(k) investments, but there is no guarantee. And your expected annual return—assuming a portfolio with 70% in stocks and 30% in bonds—is more like 5.5%.

About 70% of Vanguard customers who have both a mortgage and a car loan, and make prepayments, prioritize the mortgage, despite the higher return they’d get by focusing instead on the auto loan.

5 OF 5

Your mortgage charges 6% interest. To get ready for retirement, should you prepay it or put the extra money into your 401(k) above the match?

1. Prepay the mortgage
2. Put more money in the 401(k)
3. It depends on your risk tolerance

If you take a tax deduction for your mortgage interest, the true cost of carrying this debt is below 6%. If you are in the 24% tax bracket, for example, your after-tax interest rate is more like 4.5%. That means you would lock in a guaranteed 4.5% return by prepaying your mortgage.

In contrast, you are likely to get a higher return by investing your money in a diversified portfolio of stocks and bonds in your 401(k).

The hitch is that the 401(k) return is not guaranteed. If you are risk-averse, you might opt to prepay the mortgage. The choice between a guaranteed 4.5% return and a potential, but not guaranteed, higher return will always be personal.

ANSWERS:

First question: 4. Saving enough in 401(k) to get the match

Second question: 3. Prepaying credit card balance at the 22% rate

Third question: 1. Yes

Fourth question: 2. Prepay your auto loan at the 12% rate

Fifth question: 3. It depends on your risk tolerance

***

To recap, three simple rules of thumb can help you think through financial decisions:

1. The utility of any given use of money, from debt payments to retirement savings, can be compared by thinking about the returns on each one. Even if you don’t choose the highest return, this will help you think about the trade-offs.
2. Take full advantage of your employer match. If your employer matches every dollar you contribute up to 3% of pay with another dollar, that equates to a 100% return. A match of 50 cents for every dollar you contribute equates to a 50% return. That is likely higher than any other guaranteed return you can get.
3. If you prepay your debt, pay down the one with the highest interest rate first.