You have debt. You also hope to retire someday. But those two goals seem to be at odds with one another. After all, saving for retirement and paying off your debt both require money -- and this means you face a trade-off.
Which one should you prioritize? Let's take a look at some of the considerations that should factor in this decision.
Advantages to saving for retirement
First and foremost: If your employer offers to "match" any portion of your retirement contribution, take full advantage of that opportunity.
Let's assume, for instance, that your company will match $0.50 for each dollar you contribute to your 401(k) accounts, up to a maximum of 6% of your salary. This means you'll earn a guaranteed 50% "return" on every dollar you invest. This is the only "guaranteed return" in the world of finance.
But what should you do after you've maxed out that employer match?
Here are some of the advantages that come with prioritizing your retirement savings:
- Tax advantages: Contributions to your 401(k) or 403(b) account, as well as to a traditional, SEP, or SIMPLE IRA, are all tax-deferred. You'll save on taxes by diverting your money toward retirement. If you pay down debt, by contrast, you'll be making those payments with after-tax income (except for mortgage interest).
- Tax exemption: Contributions to your Roth 401(k) or Roth IRA account are tax-exempt, which means you'll contribute after-tax income now, but you won't have to pay taxes upon withdrawal. Debt repayment, by contrast, provides no such advantage.
- Market gains: Between 1990 and 2010, the S&P 500 returned an average of 9.14%. If this is higher than the interest rate on your debt, then you might face a strong argument for investing your money, rather than concentrating on debt payoff. Many people who finance cars at a 1% to 2% APR, for example, may be rightfully reluctant to sacrifice their potential for higher market gains. Even conservative fixed-income investments might outperform the low interest rate they're paying.
- Inflation: Federal interest rates are at historic lows, which causes many analysts to believe we're heading into an inflationary environment. Assuming your debt is held at a fixed interest rate, inflation is your friend. It means you can repay your debt in cheaper dollars.
Advantages to paying off debt
All that being said, however, there are many benefits to prioritizing debt payoff:
- Risk reduction: No matter how secure your job might seem, your income potential is volatile. Reducing personal debts puts you in a position in which you can comfortably face a layoff, a job change, or any other personal crisis. No one with a paid-in-full home faced foreclosure during the last recession (that is, unless they neglected their property taxes).
- Interest savings: We may hope to outperform our debt interest rates in the stock market or bond market, but those potential returns are only hypothetical. The interest savings on our debt, however, are a guaranteed "return" on our money. If we pay off a mortgage with a 4% interest rate, in other words, we're guaranteed to "earn" 4%, risk-free.
- Free cash flow: Once your debts are paid in full, you'll have excess cash that you can use for investing. For example, if you're devoting $1,500 per month toward the principal and interest portion of your house payment and $400 per month toward your car, you'll suddenly find yourself with a spare $1,900 on hand once your debts are repaid. You can then choose to devote every dime of this "extra income" toward investments. Yes, you'll defer the advantages of compounding interest on your investments by applying your money toward debt payoff first. But you'll also reduce your risk and free your cash flow, which is worth something.
- Sleep easier: Legendary investor Philip Fisher said that conservative investors sleep well. Debt payoff (and the corresponding risk reduction) might result in a more sound night's sleep, the benefits of which are incalculable.
- Lower debt-to-income ratio: I know, I know -- it seems a bit silly to say that one of the advantages of paying off debt is that it allows you to take out more debt. But your debt-to-income ratio is a critical factor in determining your eligibility to take out a new loan. And there are only two ways to improve this ratio: either increase your income or reduce your debt. By reducing your debt, you make yourself eligible to take out another loan in the event that a great opportunity comes by. Let's imagine, for example, that you find your dream home, and it's priced far lower than it ought to be. With a lower debt-to-income ratio, you just might qualify to buy it.
So which should you choose? Should your retirement planning strategies involve maximizing your accounts up to the federal limit? Or should you pay off your debt first?
There's no single "best" answer. Your decision should take into account your age, goals, risk tolerance, tax bracket, and debt-to-income ratio, as well as the interest rate of your debts, the payment and amortization schedule of your debts, and the "opportunity cost" associated with each option.
Let's look at a few hypothetical examples to illustrate this (all examples assume that you're already maximizing your employer's matching contribution):
- John is 24. He holds $10,000 in student loans, that carry a 3.5% interest rate. He earns $40,000 per year, and he's highly risk-tolerant. He should prioritize saving for retirement, because his debt-to-income ratio is low, his interest rates are low, he doesn't mind volatility, and he's young enough to take advantage of compounding gains in the market.
- Emma is 42. She carries $12,000 in car loans at 2.5% APR and $5,600 in credit card debt at 14.9% APR. She earns $75,000 annually and has a medium risk tolerance. Emma should pay off her high-interest credit card debt. After that, her decision is a toss-up. She may want to prioritize her retirement savings, as her debt-to-income ratio is low and she's young enough to enjoy 20 or more years of market growth. On the other hand, her car loans are so small relative to her total income that she might enjoy the peace of mind that would come with demolishing that debt.
- Edgar is 62. He owes $23,000 on his mortgage at a 5% interest rate, and he plans to retire within the next three years. He should pay down his debt so that he can enter retirement debt-free. He's also at a stage in life when he should be investing conservatively, with an eye toward income rather than growth, so there's a slim chance that his investments will outperform his APR. He'll be better served by freeing himself from a mortgage payment during his golden years.
If you're trying to decide which option fits you best, write out a list of all your personal attributes: your age, goals, timeline, risk tolerance, and debt-to-income ratio. Once you read your personal attributes on paper, you'll be more likely to sketch out the scenario that best suits your situation.
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Paula Pant is a contributor to WiserAdvisor.