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Should You Pay Off Debt or Invest for Retirement?

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.

Final verdict
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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Read/Post Comments (4) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 15, 2014, at 12:59 PM, jmsenk wrote:

    Well thought out article. I especially liked the three scenarios and making reccomendations based on their situation. I am tired of reading articles who tout the benefits of living debt free, and especially people who comment about how "debt is the currency of slaves!" - I am a young man in a stable career, why in the world would I want to pay down a 3.5% mortgage, or a 2% auto loan when my money could be working hard elsewhere. People build up excellent credit for a reason, and often that is an untapped resource of personal capital.

  • Report this Comment On January 17, 2014, at 5:23 PM, BruceBenson wrote:

    The two times in my life associated with a significant increase in assets were both centered on paying off debt. The first when I was young and deep in credit card debt, I literally cut up my credit cards. After a few years of extreme frugality I learned that if I could afford to pay credit then I could afford to save and pay cheaper with cash. I never went into credit card debt again. The second was during the dot com bust where I had stable income but the stock market was dropping. I decided to pay down my mortgages (3 houses, 2 of which were rentals) instead of investing or holding the money. I became debt free and, for example, can buy new $30K+ cars with cash. I have no idea what my credit score is and the great recession had really no impact on my family though I was laid off, started my own business, and had teenagers about to go to college. Living well within my income, investing, and eliminating debt was, for me, key factors in achieving financial independence well before traditional retirement.

  • Report this Comment On January 18, 2014, at 5:01 PM, jrosiak2 wrote:

    OK, I'm looking back on these questions since I'm 72 and retired. As the article says, "There are no pat answers" but I would like to share a bit of my experience if anyone is interested.

    My wife and I have always lived quite simply. For us, buying a house was a high priority. Each time that we bought a house we were very careful to consider what we could afford, and not what we wanted. I'm an Accountant and I really like the advantages of home ownership so we didn't mind financing an appreciating asset. There are also some great tax advantages in home ownership that came in very handy. On the other hand, we sold one home because I wanted to be in better position for a transfer that would be a step up in my career.

    Regarding a car, I chose to buy used rather than new. That decision was based on the fact that we didn't drive a lot of miles each year. Again, we chose to buy what we could afford and added maintenance into the monthly costs of driving. Most people don't maintain their cars properly so when they need a new car it's often an urgent matter. We paid off our cars and then set up a car savings account once they were paid off. Having a good down payment put me at an advantage. I also found a good, trustworthy mechanic and followed his advice. When I bought cars I used Consumer Reports Magazine.

    When it came to retirement savings we made them a high priority...higher than vacations. One approach that helped me was to have my taxes over withheld so I got a chunk of money that I could put into IRA's each yr. That's not the way that the "experts" say you do it but we ended up with a pretty decent nest egg. We also invested in our 401k plans...more than the minimum. In addition we NEVER took a loan against our savings.

    There are many other things that are important in the financial part of life so it really comes down to balance. For smaller purchases, like furniture, we saved up in order to avoid finance payments. Not only did that save money it also helped us to develop financial discipline.

    The ending of this story is that we retired debt free with an adequate amount saved in order to do the things that we wanted.

  • Report this Comment On April 12, 2015, at 8:59 PM, alfredfrancis101 wrote:

    Payoff of course.

    First my comment is based on 2 principles based on Dave Ramsey:

    1. Power of focus

    2. Personal Finance is 80% behavior, 20% head knowledge

    Most people who are in consumer and auto debt are usually not disciplined with money. They don't have a tight monthly budgets. Their definition of "I can affort it" is based on monthly payment affordability. When they change their behavior, they are on their way.

    I can only speak for myself, I got the "stupid T-shirt". I'm glad I was able to read the "Millionaire Next Door" and Dave Ramsey's teachings.

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