Should I pay off debt early or save more money for retirement?
How do you choose what goal should be at the top of your priority list? This question becomes especially tricky when you try to decide which to do first — pay off existing debt or save for retirement? In fact, this is one of the most common questions people ask financial advisors.
When you want to do both of these things, the "right" answer isn't always easy to find. Here's how to solve this puzzle so you can decide what belongs at the top of your list.
Financially speaking, prioritize the goal with the higher rate of return
If you want the short and simple answer to this question, just do the math. Jean Chatzky says you need to look at the average rate of return1 on paying off your debt versus the average rate of return on savings for retirement. Whatever rate of return is higher — that's the goal you need to prioritize.
To find the rate of return for paying off your debt, just look at the interest rate you're currently paying. That's how much you'll save each year by not carrying that extra debt. For example, if you're currently paying 12% interest, then that will be your rate of return by paying off that debt early.
As for the actual rate of return on your retirement savings, you won't know this for sure until you actually use it at some point in the future. However, to make the best financial plan for yourself, a reasonable educated estimate is that your nest egg will return 7%. That's been the average return of the S&P 5002 since the 1950s, although it's important to note your investments may perform differently depending on your individual portfolio and how you manage it.
Let's look at a couple of examples:
Say you have a loan with a 3% interest rate. You assume you can get a 7% rate of return by contributing to your retirement savings if you invest that money. In this case, you should prioritize saving for retirement because that option provides you with a better return in the long run.
However, let's say you carry a credit card balance with an interest rate of 15%. This is more than double what you can reasonably expect to earn by saving for retirement. So the best decision would be to pay down your debt faster.
If you feel comfortable doing the math — and then doing what the math suggests — determining the best option can be quite straightforward. But we don't live our lives in spreadsheets, and the optimal financial choice might not be the best choice for you depending on other factors in your life.
Tip: Look at the average rate of return on your debt and on your retirement savings to help you determine where to put your money.
When it makes sense to pay down debt faster
Even if you carry debt with a relatively low interest rate — low enough that the math would suggest that you should focus on saving for retirement — there are a couple of instances where it might make more sense to pay off your debt instead.
You want to finance a house or car soon. If you hope to get a car loan or mortgage in the near future, lowering your debt-to-income ratio could be the key to qualifying for a better interest rate — or even qualifying for a loan at all.
Your debt is causing you serious stress or anxiety. Sure, the math matters. But how you feel about your debt matters too. Some people simply can't stand the emotional weight of debt. If that sounds like you, getting rid of your balances ASAP will likely be the right choice for you.
When it makes sense to save more money for retirement
Even if you carry debt with an interest rate above 7%, you might want to keep retirement savings high on your priority list if:
You have a 401(k). If you have a 401(k) or any other kind of retirement plan in which your employer will match some percentage of your contribution, contribute enough to get the full match. This is like free money from your employer, so don't leave it on the table.
When it makes sense to do both (yes, this is an option)
The issue of paying off debt versus saving for retirement doesn't have to be an either/or question. If you can afford to put a little more toward retirement while also making more than the minimum payment on your balances to pay down debt faster, go for it! You'll be in a better financial position in the long run if you can put more cash toward both goals at the same time.
To do this, you might need to create a budget or look at where you can cut back on costs to free up more cash. Consider cutting back on discretionary spending (like entertainment, meals out, and expensive vacations). Also, you might be able to find ways to earn more money (like picking up more hours at work, trying your hand at freelancing or consulting, or helping your neighbors out with odd jobs).
Feeling motivated? Make the most of your efforts by tackling your goals strategically. We can help you work smarter, not harder. Give us a call at 1-888-SYNOVUS (1-888-796-6887) and we'll connect you to a financial advisor.
Important Disclosure Information
This content is general in nature and does not constitute legal, tax, accounting, financial or investment advice. You are encouraged to consult with competent legal, tax, accounting, financial or investment professionals based on your specific circumstances. We do not make any warranties as to accuracy or completeness of this information, do not endorse any third-party companies, products, or services described here, and take no liability for your use of this information.
Business Insider, "A financial expert says deciding whether to save or pay off debt comes down to a basic math question," Tanza Loudenback, http://www.businessinsider.com/jean-chatzky-saving-or-paying-off-debt-2017-6, April 21, 2018.
New York University, "Annual Returns on Stock, T.Bonds and T.Bills: 1928 - Current," Aswath Damodaran, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html, April 22, 2018.
Debt.org, "How to Prioritize Retirement Savings vs. Debt Payoff," Bill Fay, https://www.debt.org/retirement/prioritize-savings-vs-payoff/, April 21, 2018.
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