Pay Off Debt or Save for Retirement – What to Do First?
Pay Off Debt or Save for Retirement-4 Factors to Consider
Michael from Studentloansherpa.com asks:
For people with existing debt, such as credit cards and student loans, is it best to pay off debt or save for retirement? I realize that the interest rate is obviously a big factor here, so at what debt interest rate does putting money towards retirement instead of debt make the most sense?
Michael, I wish it was that simple, if your interest rate is x percent, pay off debt; if your interest rate is y percent, then save for retirement. Like many investing and money questions, there are several factors to examine when deciding whether to pay off debt or save for retirement-or even tackle both at one time.
1. Does Your Employer Offer a Retirement Plan Investing Match?
Would you walk past $1,000 on the sidewalk or would you bend down and pick it up? This isn’t as stupid a question as it sounds. In fact, many workers are doing just that-walking past $1,000, $2,000, or more in free money every year.
If your employer matches a certain percent of your investment in a workplace retirement account, you must contribute up to the match amount. Imagine that Katie earns $50,000 per year and that her employer, Creativity Company matches the first 5 percent Katie invests in the company 401(k) plan. So if Katie invests $208 per month in her retirement plan, the employer chips in an additional $208 for a total $416 per month investment. (Monthly salary is $4167 x 5%=$208). If Katie skips retirement investing until her debt is paid off, then she’s throwing away $2,496 ($208 x 12) in one year.
Regardless of your debt level, invest up to the employer match.
2. Pay off Debt Until it Hurts
I know, many of you have mountains of credit card and student loan debt. And it seems impossible to pay it off.
Understand that by hanging on to debt, you are not only paying the original amount of the loan, but interest payments that don’t stop until the debt is gone. Depending upon how long it takes to pay off $20,000 debt, you could end up paying up to $50,000 in principal and interest payments if you string out your repayment.
Think about this, if your average debt interest rate is 11 percent and a diversified investment portfolio averages a 7 percent average return, you’re losing 4 percent interest by investing while paying off debt (11% debt interest rate – 7% investment return).
Do not delay, start paying off your debt today.For a personal story about the beginning sacrifices of my investing background, download the free Investing Cheat sheet.
3. Pay Off Debt or Save For Retirement (if you lack an employer retirement match)
This is a more difficult decision. There are many factors to think about when tackling this decision. But, I’m going to make it a bit easier for you.
Contribute to a retirement account and pay off debt.
Would you believe that if you start contributing to a Roth IRA or other type of retirement plan at age 25 versus starting at age 30 or 35, you can net hundreds of thousands more dollars at retirement. There’s a great benefit to starting retirement contributions in your 20’s.
See how much money you gain by starting to invest earlier.
Start contributing $400 per month at age 25 into a retirement account and stop contributing at age 68. Assume you earn an average of 7 percent over 43 years. At retirement your $400 monthly contribution (total amount contributed is $206,400) is worth $1,318,096. Your initial investment increased over 6 times.
Wait just 10 years until age 35 to start investing. Contribute the same $400 per month and stop contributing at age 68. Assume you earn an average of 7 percent over 33 years. At retirement your $400 monthly contribution (total amount contributed is $158,400) is worth $621,228. By waiting 10 years to invest, your retirement contributions increased less than 4 times.
There are many scenarios to consider when considering whether to save for retirement or pay off debt, but the most important thing to understand is the time factor in growing your wealth. The longer your money compounds, the easier it is to build substantial wealth.
This simple example doesn’t take into account an employers possible contribution towards retirement nor increasing the retirement savings amount.
Are you willing to endure a few years of cutting back and discomfort in the earlier years of your career in exchange for a wealthy future? That’s the question you need to answer.For a personal story about the beginning sacrifices of my investing background, download the free Investing Cheat sheet.