It’s no secret that most of us are saddled with debt from student loans, credit cards, mortgage payments from a first home or any combination of all three. Couple repaying these debts with the seemingly momentous task of trying to save for retirement and we have some pretty difficult decisions to face regarding which issue our money should be thrown at first.
Determining whether to put your extra cash towards retirement or paying off debt isn’t always a simple black and white decision. On one hand using the money to pay off debt with a hefty interest rate attached to it seems like a no-brainer.
Knock out the debt burdens now and then focus on saving for retirement once you’re in a more financially stable position. Yet if you put off saving for retirement now you may lose the main advantage of investing while you’re younger; time. So how do we figure out what to tackle first?
Interest Rate of My Debt vs My Investment Rate of Return
One way to solve this conundrum is to compare the potential investment returns against the interest rates you are paying on the debt. For example, if you have a credit card debt with a 15% interest rate and then use your excess money to get rid of this debt, you are effectively getting a 15% return on that excess money.
You would need to earn a return of 15% from your investments to make saving for retirement the better option than paying off your debt. And let me say, a 15% rate a return is a pretty lofty number to obtain for the average investor. In this simple scenario, eliminating debt first would probably be your most prudent choice.
What If My Employer Matches My Savings in the Retirement Plan?
Well now that becomes a bit more complicated. Let’s imagine that your company matches the first 3% of your contributions to your retirement plan 100%. In other words, for the first 3% of the money you put into the plan you are earning a rate of return equal to 100% on that money from your employer.
Good luck finding any other place where you are able to receive a 100% return on your money by simply saving in your employer’s retirement plan. Additionally, you may have the benefit of being able to defer taxes on the money you contribute to the plan. This in turn potentially reduces your federal taxes for the current year and defers them to a later time (when you withdraw the funds for retirement).
So How About a Combination of the Two?
Imagine you have that credit card debt with 15% and you employer also offers a 100% match on the first 3% of contributions. It may be wise to use some of your excess funds to pay off that credit card debt while at the same time making sure you contribute enough to your employer plan so that you are able to receive the full 3% match.
You May Want to Consider…
- When contributing to retirement savings, compare your potential rate of return to the interest rate on your debt
- If you focus on retirement make sure you have enough money set aside to pay monthly minimum payments for your debt; larger interest rates and late fees are no fun for anyone
- Refinancing high interest rate debt at lower rates will allow greater flexibility in contributing to both goals
- Withholding money from your paycheck for retirement contributions or direct payments on debt may prevent the urge to skip retirement contributions or debt payments
So what are you waiting for?
The most important step is just getting started toward your saving goals. Forgetting the numbers for a second, something can be said for the mental burden that’s released when debt has finally been paid off. But whether you choose to pay off debt or save for retirement, once you get the momentum going you’ll be well on your way to accomplishing both.
Any opinions are those of Jacob Dahlstrum and not necessarily those of RJFS or Raymond James.