One of the questions I’m asked quite often, is whether it’s better to pay down debt or save for retirement.
The answer, as is almost always the case in personal finance, is that it depends. Both are smart moves and the right decision depends on the specifics of your situation, the goals you’re trying to achieve, and, to some extent, your personal preferences.
Let’s dig into it.
How to Think About Paying Down Debt vs. Saving for Retirement
There are three big factors you need to consider when you’re trying to make this decision:
- Return — Which route gives you the best chance at the highest return? This is simply a matter of comparing the interest rate on your debt to the expected return on your investments.
- Certainty — Of course, not all returns are created equal. Paying off debt represents a guaranteed return at the rate of your interest rate. Investing offers the possibility of higher returns, but also the possibility of lower, or even negative, returns.
- Peace of mind — Sleeping at night is important too. If the other factors are close, you shouldn’t hesitate to choose the route that makes you the most comfortable.
I also like to establish some emergency fund savings to support both goals. With those things in mind, here’s a rough order of operations you can follow to help you make this decision.
1. Make the Minimum Payments on All Your Debt
The first step is always making at least the minimum payments on all your debt.
Doing so keeps your credit score in tact and prevents you from having to pay late fees or, in a worst-case scenario, defaulting on your loans.
2. Take the Full Employer Match
Beyond making your minimum loan payments, it’s almost always a good idea to take full advantage of any 401(k) employer match before even considering putting extra money towards your debt.
That match is typically an immediate 50%-100% return on investment, which is better than paying off even the highest interest debt.
One additional consideration, is your company’s vesting schedule. If you’re not sure you’ll be with your company for long, and if that employer match takes a few years to vest, it may not be as valuable.
3. Pay off High-Interest Debt
Going back to the three factors above, paying off high-interest debt represents both a high return and complete certainty, which means that making it the next priority is likely the best choice.
So what exactly qualifies as “high-interest”? There’s no golden rule here, but there are some useful guidelines to consider.
Experts typically expect long-term stock market returns to fall in the 7%-8% range, but of course nothing is guaranteed. It could be higher or it could be lower.
Given that paying off debt represents a guaranteed return, anything with an interest rate in the 7%-8% range or higher should likely qualify as high-interest. At that point you’re guaranteeing yourself a return that’s just as good or better than the expected (but not guaranteed) return of the stock market.
But it’s even worth considering prioritizing debt at interest rates lower than that, for two main reasons:
- Again, paying off debt is a guaranteed return, which is not something you’re going to get from your investments.
- Your investment portfolio will likely include a mix of stocks and bonds, which means that your personal expected return will likely be lower than 7%-8%.
The exact cut-off point for “high-interest” debt is largely a personal decision based on circumstances and preference. But you can use both historical and projected investment returns as a guiding light.
4. Consider Your Motivation
Once you’ve taken full advantage of your employer match and you’ve paid off all your high-interest debt, there’s both math and motivation to consider.
On the one hand, it may be smart to save extra money for retirement over paying off low-interest debt simply because of the difference in expected return. You’re likely to earn more by investing that money, especially if you’re contributing to tax-advantaged retirement accounts.
On the other hand, making continuous positive progress is more important than making the absolute optimal decision from a math perspective. If paying off your debt gives you peace of mind and motivates you to keep making positive financial progress, that may be the best route regardless of your interest rate.
Strike a Balance
Sometimes there’s an easy answer to this question. Taking full advantage of your employer match is free money. Paying off high-interest debt is a guaranteed return.
But in many situations it makes sense to strike a balance instead of thinking of it as either/or. Both paying down debt and saving for retirement are great goals, and contributing money towards both may provide the best of both worlds.
Image courtesy of: https://www.bellavistahealth.com/blog/2017/6/26/difference-between-short-term-care-and-long-term-care