Updated on 08.14.08

The Big Debate #4: Pay Off Debt or Save for Retirement?

Trent Hamm

?This week, The Simple Dollar is taking a deeper look at five common personal finance debates.

Once a day or so, I’ll get a long email from someone pouring out the details of their personal finance situation. Quite often, they’ve reached an age where they’re starting to seriously worry about retirement and have realized that they’re way behind where they need to be. Usually, this revelation is coupled with an astounding debt load – quite often, they list their debts, and they add up to quite a pretty penny.

Then comes the big question: what do I do? Most of the time, the situation is salvageable, but it usually points to a path of a lot of frugality and hard work – and quietly I wonder whether they’re up to it or if they’re going to keep working until the very end of their days.

Their question usually boils down to what personal finance need do I tackle first? Should I start hacking away at all this debt, or should I start socking my cash away for retirement? It’s not an easy question, actually.

What Are The Options?
Usually, you’re asking yourself what to do with roughly 10 to 15% of your income. Should you use it to repay debt, save for retirement, or a combination?

A debt repayment plan essentially means you’ve determined an orderly plan for repaying your debts and have committed a certain amount of money each month to eliminating them. Let’s say you’ve committed $500 a month and your minimum payments are $400 – that leaves $100 as an extra payment on one of the debts after all minimum payments are handled. When you pay that one off, you still use $500 a month but your minimum payments are less, meaning you can put a larger extra payment towards the first debt.

Saving for retirement, on the other hand, means you’re committing a certain amount each week or month towards an investment account for your retirement, as discussed earlier this week.

So What Should I Do?
I don’t think the choice is necessarily one or the other. I think the best solution for someone facing debt issues and the need for retirement is a hybrid of the two.

The most important thing is to make sure you’re not throwing any money away. This means making sure you’re hitting the minimum payments on all of your debts. It also means, if you have a 401(k) plan, that you’re contributing up to your employer’s match. If you’re not doing these two things, you’re throwing money away on late fees or lost contributions – and now is not the time to be throwing money away.

The first big step is to get a grip on your spending. If you’re in a situation where you have strong retirement needs and strong debt elimination needs, you need to trim back the spending hard. Stop eating out. Cut back on or eliminate your travel. Stop shopping for entertainment’s sake. Look at your hobbies carefully. Trim any fat you can from your monthly bills. You got into this situation by overspending and the only way out is by underspending.

The next big step is to compress your debts as much as you can. Call your credit card companies and ask for some rate reductions. Do some zero percent balance transfer offers. Look for other opportunities to get those rates down, such as home equity loans or personal loans. Here are some strong tactics to use.

Next, figure out how much you need to be saving for retirement. Figure out when you want to retire and how much extra money you have each month at this point, then go to your retirement specialist at work and see what you can do. They’ll probably move you to more aggressive investments and suggest you use most of the cash for retirement. You should consider seriously working while retired.

If there’s anything left, use it to hammer on your debt repayment plan, but if there’s any real key to solving this debt versus retirement conundrum, it’s learning to live cheaper. If you don’t do that – and do it with all your heart – you’ll be working for the rest of your years.

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  1. Save the most you can to get a company match, then pay off debt. Debt is a constant dependable interest rate, investments are not. Take the guaranteed.

  2. Movingonup! says:

    I did a combination of saving for an emergency fund, contributing to retirement, and paying off credit cards. I put about 10% to each category. I don’t have much money to spare each month, but I feel like I’m accomplishing everything.

  3. Kevin says:

    I think another thing you need to take a look at in this debate is what rate you expect your investment to grow vs. what interest rate you’re paying on the debt. It doesn’t make much sense to invest in stocks/funds that you hope will make 10% annually when you’re carrying a balance on a credit card at 18%.

  4. JB says:

    I agree -> I believe you have to pay down debt. If your budget is so tight that you can only choose to do one of these, you must pay down debt. If it’s possible that you can squeeze a little bit into retirement while paying down debt – I would recommend that… but first thing is pay down debt.

  5. Miranda says:

    I like the idea of consolidating your debt as much as possible as you start your debt repayment plan. I agree that it is a good idea to pay off debt. But not at the complete expense of your retirement. Since many agree that 15% of your monthly income is wasted, you can use this to do both. What if you did 10% to debt reduction and the other 5% to retirement. Of course, once the debt is paid off, you should take all of that debt repayment money and put it into your retirement account!

  6. I lean towards paying down the debt first, but I think the wisest thing is something like Miranda suggested…more towards debt, but a little towards retirement too.

    We don’t have any debt aside from our mortgage, but there are a lot of things we need to save for along with retirement(a new car fund, a better emergency fund, etc), so we can’t put tons of money into the 401K right now. At least we’re contributing something, though.

  7. Amp says:

    “They’ll probably move you to more aggressive investments” I have to disagree with this: aggressive investments are _risky_ investments, and someone facing retirement in the near future should be investing in _safer_ investments, even if that means foregoing the greater returns possible in aggressive investments.

  8. clint lawton says:

    pay off debt always…it is hard to get a garenteed 7% return (that is what most mortgages are at).

    Just thinking.

    clint lawton


  9. Kevin et al.
    What we must absolutely not forget is that we are paying down debt and investing with “after-tax dollars”.
    In that same token, the return on your debt repayment is absolute while the rturn on your investment (unless in a Roth IRA)will eventually be taxed. Therefore, our retun on investment (ROI) must be higher, even after tax, than the return on paying off debt.
    If your mortgage is at 6% interest you may need to earn 8% or higher on your investments before tax in order to get the same real return as paying down your mortgage.
    In addition, the ROI on paying down debt is guaranteed and that usually means that paying down debt is a higher “risk adjusted” return on investment.
    Just my $0.02
    – Tyler

  10. Tyler – Amen brother. On top of that, with tax rates going way up when Dems take office, a paid off mortgage for a retiree is a good way to put imputed income into your pocket (shelter) without being taxed on it.

  11. plonkee says:

    I think that habits are important. And it’s a good habit to put money away towards your retirement, doing so whilst you’re repaying debt reduces the risk that you’ll get to being debt-free and forget to start investing.

  12. Excellent post, Trent. I like what you said about contributing at least as much to your 401(K) as your employer will match. It is senseless to leave that money on the table each year.

    I have friends that are in high debt situations, yet they refuse to cut back on eating out, going on weekend vacations, or taking out their boats. The biggest obstacle to debt reduction seems to be holding the line on spending. Many of my friends feel a sense of entitlement.

    I try to discuss starting some kind of home business to bring in extra money and reduce their tax burden, but they see that as too much work.

    I have emailed links to your site to them, but until they connect emotionally (fear) with the reality that they are way behind and will not be able to retire, your excellent advice goes unheard.

    Keep up the good work. You make sense to your readers.

  13. Jayson says:

    I’m all for paying down debt. I personally don’t have any except for my mortgage. I put in 6% of my check for my 401(k) (that’s what the company will match) and the rest pays off my house.

    There are not a few investment advisors out there who say this is a really bad idea. My perspective. Once the house is paid off, I don’t need nearly as much money during retirement. Also, if I happen loose my job (or I die and leave my wife and kids) all I have to cover is food and utilities until I can find something else.

  14. SK says:

    Trent, I see that you have a reader mailbag in which you address the readers questions, but I dont know where to post my question for that. So, here it is, though it may be off-topic..
    I dont know if I belong here.. I am a bachelor, 26 right now, planning to get married early next year. I have always been a major proponent of the simple statement “Your expenditure should never be more than the Income” month after month after month. I spend decently lavishly, eat lunches out, dont cook at home, but I still manage to save one out of the two paychecks I receive in a month. That is, half of it. In my current spending of half monthly pay, I match my company’s 401(k) full match and I have a long way for retirement. I recently paid off my 22k car (Camry so has a lot of life on it still) out of savings after considerable thought if I should hold it in CDs versus paying off the loan but my 4% on savings was far less than my 5.5% car loan. I saved up around 85k by now. All of it is in either short term CDs or in Savings accounts. The problem now is, lately I have been thinking a lot, as to why should I save now any more. At times, I think, I should spend my entire pay check from the next month at least until my marriage. Some times, I dont understand why I should save any more. So my question is, after a certain level of savings when you are debt free, what is the incentive for saving? Why should you save any more?

  15. shahrul azwad says:

    True, we must start by living cheaper.

  16. Yep. To me it is a no brainer. Get that miserable debt paid off before you even THINK about doing anything else.

  17. chris says:

    Reduce excessive spending and apply savings toward debt reduction. Saving a few dollars here and there add up quickly. If your debt load is not out of control, then apply a small percentage towards retirement. As your debt shrinks, gradually increase your retirement contributions.

  18. Stop spending on non-essentials is the best advice. When friends are facing increased mortgages or have temporary setbacks, the best advice is to curb non-essential spending. No eating out and cut back on that entertainment budget.
    Most friends of mine just struggle to get an emergency savings account set-up and are far away from any type of long term investing strategy.
    We also need to get away from the thinking that debt is unavoidable when having a family. We created the debt, so why can’t it be avoided :)

  19. Ed says:

    This is a great article, Trent. When paying down debt, retirement is often left out of the usual equation. I am currently doing my best to get out of debt (and documenting it at http://ednessindebt.blogspot.com). Yet, having received a tiny raise a couple months ago, I promptly increased my contributions to the ol’ 401k. At least that way I could be sure to pay less in taxes and pay myself first.

  20. Frugal Dad says:

    I’ve been pouring so much of my income into debt repayment for the last couple years that I have neglected saving for retirement. This post, and my own soul searching, have me rethinking that strategy. Perhaps I should be ramping up retirement contributions and using what’s left to knock out debt. I’ll have to crunch some numbers over the weekend, but thanks for providing the food for thought!

  21. Brad says:

    What good is saving for retirement if you have a massive debt load? I think for someone in this situation, they would need to face the ugly truth. Two or three jobs with great intensity because time is running out kind of deal. It’s not pretty but neither is the mess they created over the years. Quite simply, eliminate the debt AS FAST AS YOU CAN, and then you can use your income to save save save!

  22. Margaret says:

    Strictly mathematically, I should be paying off debt and not contributing to retirement, but psychologically, it freaks me out not to have anything in my RESP even though I have debt. Of course, DH says that as soon as we get out of debt, he is going to buy a boat, so we will be in debt again, so apparently we will NEVER dig ourselves out, so if I wait to be debt free, I will be waiting forever.

  23. Shevy says:

    I agree that doing both is the best idea. We’re paying down debt and putting a small amount (about $100/mo between us) into our RRSPs and another $50/mo into an RESP, which is a way to save for post secondary expenses.

    Neither of us currently has an employer pension plan with matching. If we did I would try my best to make sure we contributed the maximum amount for the match. However, we are leaving money on the table with the RESP because the government will add a percentage of what you contribute annually, up to a maximum amount and we’re not contributing at that level.

    Perhaps that’s shortsighted of us, but we don’t feel we can afford to put that much more into our daughter’s educational savings, especially when you consider that we wouldn’t get the govt percentage if she chooses not to continue her education.

    Once we have no debt I would want to put most of the money that’s currently going for that towards our RRSPs but also modestly increase the RESP contribution.

  24. Paul says:

    Doing the math to compare a maximum debt reduction vs a maximum retirement contribution strategy is fine, but don’t forget the tax implications. If you zero out your 401K or IRA contributions to go full force against the debt, you lose a substantial tax benefit. Makes you wonder if the government is encouraging us to stay in debt…)

    You can make a rational decision based on your situation (marginal tax bracket, employer 401K matching, expected rates of return, debt interest rate, etc). Just be careful that you include all the factors.

  25. cynthia says:

    Retirement is a long term investment. The earlier you put money in the longer your time horizon for growth. For most people it is the last 7 to 10 years before retirement that really adds to the principal because of the “magic” of compounding. So, if you save $200,000 by the time you are 55 or so, by 65 or so–with no new investments–that money would typically have doubled at a fairly conservative rate of return. So, if you focus on paying down debt only and not contributing to retirement you are losing out on a big bang for your bucks in the long haul. this is my two cents, anyway.

  26. Lurker Carl says:

    This is something that depends on your income, debt load, and age. The level of each requires a unique approach, one size does not fit all.

  27. Lurker Carl says:

    The amount of money allocated to funding retirement versus debt reduction depends on your income, debt load, and age. The level of each requires a unique approach, one size does not fit all.

  28. Johanna says:

    I think it depends on how confident you are that once you pay down the debt, it will remain paid down. If the debt is things like student loans or credit cards that you are no longer using (say, because you’ve had a big increase in income or decrease in expenses since the days when you ran up the balance), then I agree with the others that you should look at the interest rates you’re paying versus the return you can expect on your investments, and do whatever is the best deal.

    But if, honestly, you haven’t quite got a handle on your spending, so that you’re adding to the debt at the same time as you’re trying to pay it down, then you should put some toward retirement and some toward the debt, so that even if you never manage to pay off the debt, at the end of the day you will at least have something fore retirement.

  29. Martin says:

    This all sounds great in theory. But life happens, even when you try to plan for things. I was focusing on debt, after three years I was four months from being debt free other than a house payment. Then bam, water heater goes up and chews up the emergency fund, followed the next few weeks by the heating system. Back in debt for another 18 months (choice, go cheap or go for an efficient system that will at least get you some payback). Then bam again, mother took a fall and busted her hip and needed help. Let’s extend the debt another six months for out of state visits and support. Oh, during this time my one kid needs braces, the other requires a bunch of dental work not covered by insurance. That’s a new monthly payment extending the debt plus a new debt. Now I need about seven grand in home improvements I’ve been putting off because I assumed I’d be debt free and have accumulated the savings to be able to pay them up front at this point (by “need” I don’t mean putting in new countertops in the kitchen because I don’t like them, I mean do it now or face double or triple the cost of repair in a few years). I’m going to have to bite the bullet and this will extend the debt at least another year.

    Sigh, what’s the saying, if it weren’t for bad luck I’d have no luck at all :-).

    The point isn’t to whine (well, maybe a little) but to point out that if I had waited until I was completely out of debt to save for the kids college and my retirement, neither would have ever happened. At first because I wasn’t particularly savy about money management but kind of knew it would be a good idea not to pass on free money in the 401K or neglect being able to help at least a bit for my kids college. Then later because even as I struggled to get out of debt things happened to keep me there. Best decisions I ever made was automatic payments to college funds and retirement. I’m essentially forced to live on less.

    So, can I fund $40K per year for college per kid? Not a chance in hell. Can I help with $5K per year, yeah.

    Am I on track to funding 100% of my current preretirement salary when I retire? Only if I go on welfare right now, I think I can match that. However will $20K per year in today’s dollars help me when I retire. I like to think so, should be better than nothing.

    And if I get out of debt in time, those numbers will definately go up.

  30. Steve says:

    I agree with Trent – you have to do both. And you need to do both to a good amount. Meaning, you have to cut those expenses and reckless spending – the very ones that got you into debt in the first place. (This doesn’t apply to everybody but it applies to most debtors.)

  31. Margaret says:

    Shevy — I’m not maxing out our RESPs either. However, when they did the changes a couple years ago, they eliminated the maximum contribution per year, so if you have the funds in the future, you can top it up. That’s what I am hoping to do — get rid of our non-mortgage debts, then spend a couple years catching up on the RESPs. Also, if your child does not use the RESP AND you have RRSP room left, you can roll it over into your RESP to a maximum of $40,000. Don’t remember if that includes the match, but it does include the earnings so you won’t get taxed on it.

  32. Margaret says:

    Shevy — I mean you can roll it over into your RRSP.

  33. My.cold.dead.hands says:

    Doing both is essential.

    You want to drive out the debt, but you also need to capitalize on the power of compound interest in your retirement. You don’t get that time back.

  34. Bill says:

    For U.S. residents, not only does traditional retirement savings (IRA, 401k, Roth, etc.) provide a tax deduction, qualified retirement accounts are also immune from creditors.

    Disability (short or long-term) is unfortunately much more common than sudden death.

    Were I to become disabled, I’d rather have $100,000 of unsecured debt and a retirement plan I had fully funded over the years than be debt free with little to no retirement savings (disability income benefits are also unavailable to creditors)

  35. Roger says:

    Another interesting conversation about an important topic. I think Trent has the right idea: cut spending, keep making minimum debt payments, start investing for retirement (in a 401(k) with a company match first and foremost), and use the rest for aggressive debt repayment. Tailor a bit to your exact financial circumstances, and you’ve got a pretty solid plan for success.

  36. Georgia says:

    20 years ago my husband and I were $34K in cc debt. Had no other debt but our mortgage which was only about $6K. I worked 3-4 jobs and lived 90 miles from home to earn the money to help pay this debt off. It was done by 2002. I started using a cc and paying it off @ month. It felt so freeing. As soon as I retired I paid off our car and we were completely free of debt.

    When I was 50, lost my job, and so deep in debt, I started putting a small amount in 403B(?) at work because I knew it would be very necessary. I could always stop it if I really needed the money. The state only matched $25. But I started at more than that. About the 2nd or 3rd yr., I realized that if I put my raise in each year, I would still be all right. After about 5 years I was told I couldn’t put all my raise in. They said I was already putting 25% of my gross mo income in. Sure surprised the dickens out of me. I didn’t think I could ever do that.

    However, that still only left $75K in savings at retirement. But it is plenty for me. I take only the minimum out once annually and I have SS & 2 very small retirements. The smartest move my husband and I made was to make our retirements a little less and have it set up as 100% for surviving spouse. So I am pretty set, along with good insurance that the state pays about 45-50% on based on my years of service. I own an old dbl. wide trailer and lot. My spending has gone down dramatically, based on fewer needs. I can go back to work for 6 mos. a year whenever I need to (per my old boss), but I hope to get some grants, etc. and finish my college degree started 51 years ago. Wish me luck. Life is good.

  37. Soo says:

    I’m in my mid-forties and have only recently woken up to the sad reality of my financial situation. No savings for retirement and a fair amount of credit card debt. My short-term solution is to consider my retirement savings as another debt at this stage (considering I am behind and have to catch up). I am therefore paying a small “minimum” amount into a savings each month whilst I pay off and snowball my other debts, intending to eventually snowball my entire current debt repayments into my saving “debt”. Thanks, Trent, for the daily motivation and advice.

  38. Paul says:

    These days, I’m finding calling the credit card companies no use at all. With the economy, everyone’s calling, and the companies are even less flexible. The calls are automatic, or you have to ask online, and they respond with “You are not eligible for rate change, etc”

  39. Julie says:

    Here is my simple stragety for both savings for the future and eliminating debt….SELL SOMETHING!
    Those boats, toys and too expensive cars. Then live within your means and enjoy your life without being ruled by your possessions.

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