Are you in a situation and wonder whether to pay off debt or save for retirement? If so, this article is for you. Being able to retire means having enough passive income to cover your monthly expenses. Since debt payments eat into your monthly surplus, paying off debt is as essential as saving for retirement. However, striking a balance between paying off the debt and saving is like walking a tightrope.
I can certainly understand and appreciate someone might favor saving for retirement over paying debt. Or vise versa. In my 20’s, I spent all the money I made, and then some! At the time, I didn’t understand the difference between good debt and bad debt and how high-interest debt could cripple my finances.
No doubt, there are many arguments to consider before deciding whether to save for retirement or pay off your debt. A financial adviser may encourage you to clear the debt first –depending on various factors – and then start to save for retirement. But before you decide, you will have to weigh the interest rates and the potential returns on your investments.
Let’s assume you are carrying $10,000 in credit card debt at 20% APR. If you pay off the debt, you’ll have a GUARANTEED 20% ROI on your money. And, considering the S&P500 appreciates about 10% a year, this an excellent deal!
In this article, you can discover three potential scenarios to choose from depending on your specific situation. Then, at the end of the article, you’ll have a better idea of whether to save for retirement or pay off debt.
Let’s get started:
To Pay off Debt or Save for Retirement? 4 Scenarios to Consider.
Scenario #1: When prioritizing saving for retirement makes sense
Here are reasons why it might make better sense to save for retirement rather than paying off debt.
401(k) Employer Match
If your employer offers a matching contribution to your 401(k), the match becomes FREE money. Nowhere else on the planet will you find free money. Further, in many cases, employers don’t offer a catch-up opportunity. So, the 401(k) match becomes a use it or lose it situation.
Assume your employer offers a 3% matching contribution. In this situation, the employer adds a dollar for each dollar you contribute from your salary. For example, if you earn $50,000 but contribute 3% of your paycheck, the employer will add $1,500 to your account every year. Therefore, at the end year, you will have saved $3,000 in your 401k.
Once you’ve maxed out your 401(k), move on to a Roth IRA or a traditional IRA. But before you make a decision, take time and learn the difference between these two accounts. If you fall below the income requirement, the Roth IRA allows investors to earn tax-free income at retirement. And, for those looking to retire early, this could be a juicy option!
What to do with low-interest debt
If you carry low-interest debt such as a mortgage or student loans and are less than 7% APR, you might agree it isn’t critical to pay these loans off. Indeed, if you can get 10+% in other investments, mathematically, you’ll come out better than if you paid off your low-interest debt.
Scenario #2: When consumers should prioritize paying off debt
According to a recent report, the average credit card APR is 20%. If you are carrying a balance at a high APR, it’s essential to pay it off as soon as possible. Or, at least, refinance it with a lower-interest loan, line of credit, or balance transfer. A debt consolidation loan might also be an option. By keeping high-interest debt, you’re likely increasing the amount of time it will take you to retire while negatively impacting your net worth.
Worse yet, if you’re making the minimum payments, and investing the rest, remember that your credit card balance may continue to grow and could take 10, 15+ years to pay off. And, it doesn’t matter how much you owe! $100, $1,000, or $10,000. If you only make the minimum payment, the bank wins because of the potentially $1000’s of interest dollars you give them.
Other High-interest Debts
Credit cards aren’t the only high-interest debt you might carry. Other loans that could come with a high-interest rate include payday loans, lines of credit, and other personal loans that could have high-interest rates. If you have any of these loans, they should always prioritize saving for retirement.
Debt Snowball Method
When looking at paying off debt, I find the debt snowball method works well. It allows you to focus your effort by paying the smallest debt first, while the others get minimum payments. After you’ve paid the first debt, you can move to the next smallest debt. Repeat until you’re left debt-free, or at least free of high-interest debt.
There’s rarely a good reason to keep contributing to an emergency fund if you have high-interest debt. Pay it off first, then focus on funding an emergency fund after. Some might have a different opinion, but, in most cases, and as a last resort, consumers can re-advance the borrowed funds in an emergency. Once high-interest rate debt gets paid off in full, consider creating an emergency fund and investing in your retirement.
Once the high-interest debt gets cleared out, you’ll face either paying down low-interest debt such as student loans, car loans, or your mortgage. Mathematically, it often makes better sense to invest the money rather than paying down low-interest debt. However, it’s not a guarantee. Also, regardless of the debt, high or low interest, there’ll be an associated payment. That payment eats into your monthly income surplus. So, the faster the debts get paid, the more money you can allocate toward investments.
Financial Adviser Option
Hiring a financial adviser is almost always a great choice. Advisers will often give you a point of view that you may not have considered. Also, they are experts in personal finance and are already knowledgeable about everything written here today.
Scenario #3: Balancing Saving for Retirement and Paying off Debt
Can you have your cake and eat it too? Maybe! In some cases, it might make sense to pay off debt and save for your retirement at the same time. To be sure, it will take you more time before you can pay off all your debt. However, if the debt features a low-interest rate and comes with a manageable payment (i.e., a mortgage), yes, it makes sense.
Further, if you have excellent credit, you might be able to get a lower interest rate on your mortgage by asking or refinancing. With 30-year interest rates hovering under 3%, the money is practically free. By refinancing AND extending your amortization to 30 years, you’ll free up monthly income in your budget to allow you to invest more.
Mortgage tip: Have a plan to pay off your mortgage, in full, just before retirement. Doing so will not only help you sleep better at night, it will free up a large payment that will eat into your retirement budget.
Final thoughts about debt and saving for retirement
Ultimately, the decision depends on the amount of interest you are paying on your debt.
Before you can settle on either strategy, consider the psychological effects of being debt free or mortgage-free. For some, it’s essential to live mortgage-free, as they might think the home is “owned by the bank”. Or, perhaps the thought could be, “What if I lost my job”. In any event, it all comes down to your comfort level.
It’s worth noting that, sometimes, borrowers can receive certain tax benefits when paying certain types of debt. For example, in some situations, the interest on mortgages or investments can be tax-deductible. Tax deductions could result in a larger tax refund at the end of the year. But like always, always consult with a qualified financial professional to get the best advice!
The question remains: will you pay your debt off or save for retirement? Let me know why, in the comments below.