Should You Pay Off Debt or Save for Retirement?
Remember the board game Life? Where you got in your nifty plastic car and “drove” your life pathway, making big decisions (college or no college?) and achieving major life goals along the way? Turns out, lowercase-L life is not that different. You have moments where you have to make big financial decisions that will impact your future in ways you can’t always easily predict. Like: should you pay off debt or save for retirement?
Look at the Pros and Cons
For big life decisions, using the old pros-and-cons lists is always a good idea. It helps to see what your decision will do in black-and-white. So let’s start with pros of paying off debt, especially credit card debt:
• Pros of Paying Off Debt
- Increases your ability to borrow money at favorable rates (so you can achieve other life goals like buying a house or investing in a business).
- Makes you financially resilient, so that every unexpected expense doesn’t turn into a full-blown emergency.
- Making a plan to pay off debt teaches you to focus on budgeting and every dollar you spend, making you a smarter consumer.
• Pros of Saving for Retirement
- Starting to save for retirement today vs. tomorrow puts time on your side: compounding interest and giving yourself the most time possible means you have to save less money in the long run.
Can You Save for Retirement and Pay Off Debt?
As you can see from the lists above, there are more pros to paying off debt. Debt constricts what you are able to do financially, limiting your horizons. “If you are saving for retirement instead of paying off your credit card debt, you will likely end up needing to use your retirement savings to pay off your debt at a later point in time,” says Raj Patel, a senior financial consultant at White Mountain Partners.
The only times it makes sense to save for retirement while you are paying down credit card debt is for the following reasons:
• You have an employer-held 401(k) retirement savings plan and your employer offers a match.
That “match” the employer makes is free money. So deduct to the maximum percentage your employer matches. If the employer matches up to 3%, then you should take 3% paycheck deductions, to earn that extra 3%. If you are deducting more than whatever your employer matches, consider reducing that rate to match the match rate — and direct that found money toward paying down your debt.
• You have a clear timeline worked out and can pay off your debt in 48 months or less.
If you have analyzed your budget and figured out how to pay significant amounts to your credit cards that will put you out of debt in two years or less, and still have $200 a month you can direct toward retirement savings, then go for it! If you are aggressively paying down debt, you can take
But if you will need more than 48 months to pay down your debt, you cannot save for retirement right now — any savings you make will be eaten up by the compounding interest on your credit card debt. No doubt, a credit card interest rate of 15% or higher will eat away any interest gains you make on your retirement savings.
Make a Plan of Action to Tackle Your Debt
So then what is next? Make a concrete plan of action to tackle your debt, today. Not having a plan and paying here and there “what you can” is a method of managing debt almost guaranteed to keep you running on the credit card debt treadmill.
Instead, consider tried-and-tested methods for tackling debt, such as a debt consolidation loan that gathers all your debt into a single payment at a lower interest rate (if you qualify). Or a debt reduction or debt relief program, which is available to you if you are experiencing severe financial hardship. Of course there’s always the snowball method: attack your smallest debt first and pay it off, then move on to the next one.
But in all cases, a plan is what you need, and paying off your debt is what is paramount. Clear your debt out of the way and you can begin saving for retirement with clear credit, a clear conscience, and a clear path to success.