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.

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