Monthly Archives: February 2021

How to Decide between Debt Repayment and Retirement Savings

How to Decide between Debt Repayment and Retirement Savings

If you are approaching retirement but have debt, you may be wondering what your options are. You may also find yourself regretfully wishing you had devoted more money to paying down debt instead of saving it for retirement. However, the debate between paying down debt or saving for retirement has been hotly contested. Financial advisors vary in their opinion on the subject, which makes sense because the answer depends on each person’s personal situation and emotions when it comes to money. However, there are some clear guidelines to consider when it comes to making this decision, and the right choice for you may not be what you expected.

The Basics of How to Approach the Question of Debt Repayment

You will likely encounter two distinct factions when it comes to the question of paying debts versus saving for retirement. One faction believes that all debt is bad and encourages you to get rid of it all before saving in earnest. The other believes that there is good and bad debt. They do not find low-interest debt concerning and say it does not need to be paid down, especially since you are likely to earn more interest investing it than you pay on the debt itself. They do believe, however, that high-interest debt needs to be tackled quickly.

While both sides have a point, you need to consider your individual situation rather than blindly following any advice. The process starts by evaluating your debts, especially in terms of the interest on them. With this information, you can make more informed decisions about how to use whatever money is left over at the end of the month.

Before you even get to the question of whether to save for retirement or pay down debt, you need to account for a few key points. First, you need to make the minimum payments on all your debts. Second, you need to take full advantage of any free money offered to you. In other words, if your company offers a 401(k)-contribution match, you should contribute up to that maximum match to take advantage of free money. This should take precedence over paying down debt, as it is a 100-percent return. Third, you need to create an emergency fund. If you do not prepare for an emergency, you could end up costing yourself a lot of money in the long run. Having this fund prevents you from taking out extra debt or putting expenses on a credit card, which will only make matters worse.

The Potential Clash between Mathematics and Psychology

If you have done all three of the above and still have money left over, then it is time to think seriously about how you will use it. For most people, the best answer is a blend of debt repayment and retirement investment. From a numbers perspective, it makes the most sense to focus on paying off high-interest debt and then channeling money into investments and continue making minimum payments on low-interest debt.

The S&P has an average gain of about 7 percent, which means that money roughly doubles every 10 years. Each dollar you save at age 25 becomes $16 by age 75. However, each dollar saved at 35 is only $8 by age 75. Putting more in investments early maximizes your gains, which are much more than the money you would save on interest by paying off a 2.5 percent car loan.

At the same time, there is a psychological component to this dilemma. Many people do not like losing money and thus become more inclined to pay down and eliminate low-interest debts. By doing this, more money can be funneled to retirement savings in the future since fewer bills will be coming in each month. The sense of freedom from debt can be a strong motivating force. If you feel like you are driven by a desire to be free from debt, then it is important to acknowledge it. While investing may make more sense, if it makes you feel uneasy, then you may want to focus on paying down your debts, even the low-interest ones, before you begin saving in earnest for retirement. Recognizing this fact up front can save you from a lot of financial anxiety down the road.

Key Considerations of Maximizing Retirement Savings

You may also wonder how to save for retirement most effectively. Avoid making the common mistake of maximizing your employer match and then stopping. Ultimately, you can contribute much more than the match to a 401(k). However, you will eventually hit a contribution limit, at which point it makes the most sense to turn to a traditional or Roth IRA due to their tax advantages. Currently, the combined maximum in contributions to a 401(k) and IRA is $25,500 for individuals and $33,000 for people 50 and older. While this sounds like a lot of money, saving a lot early on takes full advantage of compounding interest and can lead to financial stability down the line. Someone who invests between the ages of 22 and 32 and then stops will have more money saved than someone who invests the same amount each month from 32 to 62, showing the real value of maximizing retirement contributions as early as possible.