Updated on 09.16.14

# Retirement Savings or Debt Repayment?

A few days ago, on my post about SmartMoney’s “7 Money Mistakes”, LTruslow left the following comment:

I have always had a problem with those who believe that you should not invest before paying off all debts and establishing an emergency fund. For many, they would never begin saving for retirement. While an emergency fund and eliminating debts are important, saving for retirement is an absolute must.

My personal feeling is that this is a strongly debatable point and it largely comes down to personal restraint and willpower.

First of all, let’s compare paying off a credit card debt with 16% interest to a 16% annual return on an investment. I worked through an example of this using Bankrate’s loan amortization calculator and some simple spreadsheet math. Let’s say Joe has \$10,000 in credit card debt at 16% and another \$10,000 in a killer mutual fund that earns 16%. His minimum payment on that credit card debt is \$167.51, which will put him in place to pay it off in ten years. Each month, Joe is going to put \$1,000 towards investment or debt repayment.

Let’s say Joe only makes the minimum payment on the debt (\$167.51) and puts the rest (\$832.49) towards investment each month for the next ten years. At the end of those ten years, Joe will have \$292,571.48 in his investment and no credit card debt.

Now, let’s say Joe puts the whole \$1,000 towards debt repayment each month until it’s gone, then the whole \$1,000 towards investment each month. Eleven months into the debt, the entire debt is gone and on that eleventh month, Joe can put \$195.04 towards the investment; every month after that, the whole \$1,000 goes into the investment. At the end of the ten years, Joe will actually have slightly more in the investment – \$296,818.21.

So, we can safely conclude that repaying a debt is just slightly better than getting that same return on an investment. Given that there’s no investment that can guarantee a double-digit return, paying off any debt with double-digit interest is the best investment you can possibly make.

The problem is that this analysis goes strictly by the numbers. It does not take into account human emotion and psychological tendencies. The truth is that if a person is in debt, there’s a good likelihood (far from a guarantee, of course) that the person would go back to being in debt once that debt is paid off.

It takes some willpower and personal strength to be debt-free in our modern world. I’m guilty of being in debt, as are a lot of my readers. It is because of this willpower factor – and the fallibility of our willpower – that it makes sense to put money away for retirement in such a fashion that it is extremely difficult to get at it.

Thus, the kind of retirement savings that the commenter describes is indeed vital, but only as a hedge against our own weaknesses. The true best path to financial freedom is not through a retirement investment plan, but through the willpower not to spend money lightly – something that’s a challenge for me and for most Americans.

1. Dough Roller says:

Looking at this issue from the psychological perspective as you’ve suggested is critical. If I had waited until after I had paid off my debt to invest, I would never have invested. The same analysis can be applied to paying off a mortgage early, even if you still have some non-mortgage debt.

2. Janette says:

I also think its important to note that if a person’s employer will match their retirement fund contribution, then its a no-brainer to conclude that contributing up to the match makes better sense over debt repayment.

3. Mark A says:

I actually wrote a post on my blog about the returns you get just by paying off that large debt vs. minimum payments on it. It is astonishing to me that people don’t understand that they only get behind when they are earning 5% on a \$10,000 CD but keep a \$10,000 balance on a credit card with a 19.3% interest rate.

4. glblguy says:

Great article, especially the part about human emotion and psychological tendencies related to debt.

5. Terry M. says:

I wonder if this analysis takes into account the tax breaks from saving for retirement.

You have a fixed \$ limit you can put into 401(k) and IRA every year. Once the year passes, you have lost the tax break for that year, forever, and you can never make it up in the future. If you spend X number of years paying debt at the expense of retirement, you have lost X number of years of retirement tax advantages.

Personally, I am paying off credit card debt, but I’m also absolutely intent on maxing out both 401(k) and IRA for this year, even though I could wipe out my debt with the contributions I’m making. The debt I can just pay off next year, but I will NEVER get back the tax breaks for year 2007 again. I’ve also earned about 3x higher returns on my retirement contributions so far this year than I’ve paid in interest, so mathematically it is making sense also. My credit card APR is pretty low (4%).

Also, it is very easy for people to get into debt again once they are out. 5 years ago I finished paying off all my debt (\$30K), and guess what? Two years later I found myself \$50K in debt. While I was paying it off, all of the credit card companies raised my limits. But it is much more difficult (both actually and psychologically) to withdraw from a retirement account.

My advice to anyone who chooses to pay off credit card debt at the expense of retirement is that as soon as you are done paying off the debt, put all of the payments you were paying to the debt, into retirement. The mistake I made is that I had no plan on what to do with the money after my debt was paid, and when my available income increased dramatically and suddenly after the debt payments stopped, I had no idea what to do with it so I spent it all.

6. Brip Blap says:

I had a different take on this on my blog. I think the key issue is ownership; whether the debt is for something owned versus something not owned. The example I use is a mortgage (not owned, the bank can take your house) versus a student loan (no-one can take that diploma back). If you look at it that way I think it affects whether there’s an urgent need to pay down the debt as much. Good points by Terry M. above, too.

7. Rob says:

Your math is wrong, though it doesn’t deter from the point I guess.

The credit card payment is right for 10 years, but the investment value is not. Over 10 years making \$832.49 contributions each month with a 16% apr gets you a future value of ~246k.

Your 2nd scenario is wrong too. Just by a bit though, since you’re assuming you have to pay no interest in the 11 months. Doesn’t matter much here, but if your monthly savings were lower, it would.

When it comes to debt repayment, I don’t think there’s a financial adviser in the world that have not recommended paying off high interest credit card debt. However, if we’re talking about federal student loans and home loans, it’s not so clear and there are many factors to take into account. Taxes, 401k matching, loan maturity, current cash, repo risk, etc…

In terms of psychology, it’s all you. A person who comes out of debt may very well get back into debt. However, it’s also true that a person already in debt tends to add ADDITIONAL debt because they think either it’ll never be paid off or that a little more doesn’t make a difference.

8. Keith says:

I like hearing your great financial advice, but most of your articles seem to throw quality of life right out the window. You seem to think that if people live a shitty depraved live until the day they retire that it will finally all pay off. This is feudal at worst, and half-hashed at best. It reminds me of the medieval christians and how they were told that a lifetime of toil would be paid off in the afterlife. I believe your lack of balance on this matter makes a great quantity of your advice worthless.

9. mike says:

i wonder how the tax savings, if applied to either further investment or debt reduction. for examle, a \$5,000 SEP contribution annually saves from \$750-\$2000 per year in income taxes, depending upon the state and tax bracket…

10. Kathryn says:

I have a related question: should we increase debt while still investing in retirement funds?

We are having to trade off between funding retirement accounts and paying tuition for our children. I was borrowing for the tuition even though I was paying into a 401K. At first, this seemed stupid. But I kept getting the common advice…” but nobody will loan you money for your retirement.” I’ve taken that to mean that we should fund our retirement first and just deal with the loans over the next several years.

In the end, we’re taking a middle road (10% into the 401K vs some student loans.) I’m having trouble convincing myself to borrow more just to max out the IRA/401K because the growing student loans are making me feel somewhat ill.

But maybe this “balance” isn’t the best solution. Would one path or the other (no debt, postpone retirement saving vs. fully fund retirement and more debt) give us better results?

11. Debbie says:

For some people, the psychology is not an important factor, so they should look at the math. For other people, the psychology affects reality so strongly that it far overpowers some ideal what-if math that will never apply to them. For example:

I think some people feel comfortable with a certain amount of debt and will always have that level of debt whether they are investing for retirement or not. So they should invest even while still in debt.

For some people, investing for retirement is their first time to see how fast money can grow at very little sacrifice to themselves, and once they see that, their motivation to reduce their debt might increase.

Also, I think retirement accounts don’t get raided in the event you have to declare bankruptcy. Nor does you main home unless it’s pretty valuable.

Kathryn – I don’t quite understand your situation. Shouldn’t any student loans belong to the student rather than the parent? I hope your children are taking some responsibility in paying for their own college. It’s been shown that working part-time in college (10 – 15 hours a week) is associated with higher grades than not working at all, and that students who are more responsible for their own payments appreciate their education more and are more likely to graduate quickly. I would just be sick if I found out my parents were raiding their retirement funds to put me through college.

If the loans are for your kids, maybe you should still let them take the loans even at these rates that make you feel ill. If they need help repaying the loans, you can always help them out then. Meanwhile, have you and your kids tried researching scholarships and other funding options?

On the other hand, college is for just a few years, and if you have enough time to get your 401Ks back in good shape by retirement, then since this strategy is helping you sleep at night, it’s a good one. I doubt I will ever earn enough to get anywhere near “maxing” a 401K, so you’re probably doing a lot better than I am, and I’m doing just fine.

12. David says:

I blogged about this today. I think that mathematically, your conclusion is valid, but there are many other factors to consider, especially for those of us that are still young (and without a family to take care of yet). The true answer is never very clear cut.

13. Rick says:

Keith: not everyone equates quality of life with spending money. Trent believes (and I am inclined to agree) that quality of life does not come from buying things. He gets quality of life from spending time with his family.

But go ahead. Live for the moment. Spend every last dollar you earn right now. But don’t complain when you hit 65 years old, and you don’t have any money to retire.

14. It also depends what type of debt you are taking on. COnsumer debt needs to be paid off and the credit cards need to be cut up – unless you can use your credit cards responsibly and pay off your balances each month.

If your debt is for a mortgage you can sometimes deduct these interest payments during tax time so some people recommend paying the minimum on house payments – but of course this adds more interest if you don’t make a extra payments to reduce your principle.

Student loans often have lower interest rates and can be seen as good debt as you are investing in yourself through education.

15. Moneymonk says:

I agree with Investeverymonth

Depends on what kind of debt, since you focus on credit cards it’s best to pay those off early, no excuses b/c they are revolving debt.

But for most (70%) people get in debt after they pay it off, so some people may never get to invest money.

16. lorax says:

Also, a 16% MF is probably going to be really risky – at least according to market theory. Returns are likely to be variable, and you might not even get the 16% pa payoff after 10 years – investments like that don’t come with an actuarial table.

17. Brian says:

So few discussions surrounding investing/debt reduction bring the pschology and emotional aspects of the people into it. Janette makes a great point about the employer matching of the 401k, as does Terry M. about the tax breaks lost for NOT funding your retirement vehicles.

There is much to be said for being debt free, but in the end, each person needs to obtain enough self awareness to choose which path will work best for them. Of course, it is only by reading all of these different perspectives that one might be able to consider the pros and cons of each and choose one or the other or a combination of both.

18. art says:

Many people are idiots. Putting the money in a retirement fund has the advantage that it’s a pain to get out and blow in the candyshop. If you give someone the “choice” of paying down a debt or having fun with the money now (after all, most of the debt is fun already had), they’ll make the wrong choice and pay whatever the minimum payment is. If the choice is “lots of bad” vs “less bad”, I’d have to advocate “less bad.”

Mind you, you should do “good”, but everyone has moments of poor judgement.

19. Peter says:

I tend to agree with the very first comment. If I’d have tried to pay off all my debt before starting some savings, I’d have screwed up. It’s great to talk about being frugal and saving for retirement but let’s face it, most of us either didn’t get any real education in managing our finances or we did and chose to ignore it.

I followed a typical path in life, college, marriage, credit card debt and car loans, then kids and a mortgage, and the only frugal thing I really did was get the matching on my employer’s 401K. If I hadn’t done that, I wouldn’t have saved anything. I’d have found more creative ways to spend it via new gadgets, gizmos, vacations, or gambling.

And the only reason I did that was because I sniffed out free money.

20. I think it comes down in the end to individual choices, for some this will be debt centered and for others it will be savings centered. Personally I go with the debt centered appraoch which is to cut your base line costs. After all most of us can live on a small amount of money providing we have paid off the major expenses in our lives.

21. Judie says:

I’d like a little input from some of you thinkers, because I’m wearing out my brain trying to find an answer. I’m 59 and have debt from a former business. This debt is killing me not only in the size of the payment, but in the interest I’m paying. As I approach my 59 and a half mark for withdrawal from my 401k, I’m considering drawing out money to pay this debt. Aside from the obvious factors, no retirement \$\$ and increased income for this year, what other considerations should I be looking for????
I’ve been paying on this debt, 30K, for years and years and have hardly made a dent in it. My payments are \$750 a month and the quality of life is non-existent. I’d be interested in hearing from some of the previous participants!