Should I Get Out Of Debt Or Save For Retirement?

The easy answer to this tough question: Put your money where it will do the most good. Compare the interest rate on the debt against the potential investment returns on the retirement savings, and choose the one that pays better. So if you’re paying 14% interest on your loans, and earning 10% interest on your retirement investments, it makes sense to pay off the loans first. After all, eliminating those interest payments is the same as earning 14% risk free. For many people, this is all they need to know. But there may be more to consider. For example:

Melinda is 23 years old. She has an $8,000 student loan (at 8% interest) and $3,000 in credit-card debt (at 14%) from a brief spending spree in college. These debts are making her nervous, and she’d like to get them paid off as soon as possible. But now that she’s eligible to participate in her company’s 401(k) retirement plan, she keeps hearing that the younger you are when you start saving for retirement, the less you need to save. She has an extra $300 per month that can go toward debt reduction or retirement savings. Which should she choose?

Robert is 34 years old. He has a $120,000 mortgage on his house (at 7% interest), and $10,000 in credit card debt (at 14%) . Having this much debt doesn’t bother Robert because his assets exceed his liabilities. His house is worth $200,000, and he has an adequate emergency fund. He is self-employed, and has an extra $500 per month that could go toward debt reduction or to begin retirement savings. What should Robert do?

Let’s start with Robert, because his choice is clear. Even though he feels comfortable carrying a $10,000 credit-card balance, the 14% interest rate exceeds the return he is likely to earn on his investments. So he should consider using the extra $500 a month to pay down this debt. (The mortgage rate is too low to worry about, and anyway it’s tax deductible.) After paying off the cards, Robert can maximize his contribution to a personal retirement plan, and put any extra money into an investment account.

Melinda, on the other hand, got a great deal on her student loan. The interest rate is only 8% and the monthly payments are just $89. She should hang onto that loan and pay it off as slowly as possible so she can use available cash for better things such as contributing to her company’s 401(k) plan, and then paying off the credit card debt.

The retirement planning people are right when they tell Melinda to start saving early. If she starts contributing now, she can save just $130 a month and have a million dollars at age 65 (assuming an annual return of 10%). But if she waits ten more years to start saving, she’ll need to save $360 a month to accumulate the same million dollars.

But wait. If she’s paying 14% in credit card interest and earning only 10% in the 401(k) plan, doesn’t it make sense to pay off the credit card before contributing to the 401(k) plan? Not in Melinda’s case, because her employer matches part of her contribution. For every $130 Melinda contributes, her employer puts in $65. That’s an immediate 50% return on her investment. And we haven’t even talked about the tax benefits yet. Not only are Melinda’s 401(k) contributions tax deductible, the money that builds up in the account will not be taxed until Melinda takes it out (generally at retirement). In the meantime, the money stays in the account to grow and compound.

If you are deciding whether to pay off debt or save for retirement, consider the following:

• Compare the interest rate on the debt against the investment returns on the savings and lean toward the one that will provide the highest returns. But remember that debt reduction provides risk-free returns. Most investments involve some risk.
• Factor in the additional benefits you get from contributing to tax-qualified retirement accounts such as 401(k) plans. These include tax savings and possible employer match.
• Evaluate your feelings. Which would make you feel better: being out of debt or having a retirement savings program in place?