Conventional wisdom says you should always make saving for retirement a priority (even when you’re young), either through a 401(k), IRA, or other plan.
Just look at this powerful example of how compound interest can make anyone a millionaire.
But is there ever a time when you should delay retirement contributions to pay off debt?
This is an important question, since many young adults are burdened by outsized student loan debts as well as a host of other debts. It can be almost impossible to make progress on other fronts, financial or otherwise, when you have large monthly payments to make.
So when is the right time to make paying off debt a priority – even to the point that you will delay retirement contributions?
Everyone who can do both should do both
Let’s make the point up front that anyone who is in a position to both pay off debt and fund their retirement plan should do so. Even though retirement is decades away, it will be important to get a leg up on investing early in the game.
In fact, if you earn a comfortable income and only have student loans, some go as far as suggesting you shouldn’t make extra efforts to pay off your debt early; instead you should invest as much as you can.
So what we’re really discussing here are those who are attempting to do both, but don’t necessarily have the income to manage it comfortably.
We can also argue, even for those who are struggling financially, that the question of paying off debt or contributing to a retirement plan isn’t an either/or debate. You can actually do both, but do so while prioritizing one over the other.
As an example, let’s say that you’re carrying a large amount of student debt, a car loan, and several fairly large credit card balances. If you’re struggling to make the payments, then you will need to prioritize paying these off. But that doesn’t mean that you have to abandon making retirement contributions altogether. You can continue to make them, but do so at some minimal level.
Here’s some financial advice on which almost everyone agrees: Regardless of your debt, you should contribute a percentage of your income that will generate the maximum employer match on your 401(k) or similar plan.
If your employer will match 50% of your contributions up to 6% of your pay (meaning a maximum matching employer contribution of 3% of your salary)—which is a typical arrangement—then you should contribute 6% to max out the employer match.
But even if this type of contribution is putting the squeeze on your budget, you can always opt to contribute 4% of your pay, to get a 2% employer match, or even contribute 2% of your pay to get a 1% employer match.
Sometimes you don’t have to turn the faucet off—you just have to lower it to a trickle. If you can do this while prioritizing paying off debt, you’ll come out ahead in the end.
Use our Loan Payoff Calculator to see how different payments and interest rates affect your loan.
When should paying off debt should be a priority?
We just discussed a recommended strategy in the event that you’re “merely” struggling with debt. But what if you’re facing something approaching a bankruptcy situation?
It’s not ridiculous question. The advent of large student loan debt has put a lot of young adults in exactly this situation.
For example, if you are earning $30,000 per year, and you have $60,000 in student loan debt, plus other debts, this could begin to describe your situation.
If that is the case, then you will have to pull out all the stops in order to reverse your fortunes.
Think of it as a divide-and-conquer strategy, where you are marshaling all of your resources to deal with the most threatening obstacle first, and holding the other for later. In this case, you should prioritize paying off your debt, and then focus your efforts even more fully on retirement savings later on, when you are in a better position financially.
The benefits of paying debt first
If you’re in a substantial amount of debt right now, then you know the emotional toll it takes. You spend time worrying how you’re going to pay your bills and meet your budget every month, let alone trying to get ahead. You may even lose sleep over the state of your finances. By getting out of debt, you will free up your mind and your emotions to freely concentrate on moving forward in life.
On a more tangible level, once you’re out of debt, you will not only have more control of your finances, but you’ll have more free cash to direct to retirement savings and other investments.
In a backdoor sort of way, paying off your debt may be the best way to maximize your retirement contributions, at least at a later date. When you are paying off your debts, you can even tell yourself that you’re doing this to help prepare yourself for retirement.
There’s another benefit that most people don’t think about. Understand that, while the terms of any loan arrangement are fixed, the results of investment activity are not. Stocks can fluctuate in value, but debt doesn’t. That is to say that there is a fundamental imbalance between debt and investments.
Worst-case scenario: while you are prioritizing retirement contributions over paying off debt, the stock market crashes and 40% of your retirement assets are wiped out. But what happens to your debt in that scenario? Nothing—you still owe as much on your debt after the crash as you did before.
In that way, paying off debt is a guaranteed investment. It not only eliminates the interest expense that the debt carries, but it also guarantees improvement in your future cash flow.
The opportunity cost of paying debt first
Here’s the problem with paying off debt and not saving for retirement:
The IRS puts limits on how much you can contribute to tax-advantaged retirement accounts every year. If you don’t take advantage of contributing up to that limit this year, you can never get that opportunity back.
This, combined with the fact that delaying investing means you lose time to grow your investments, is a compelling reason to save for retirement even if you have debt.
Related: 23 Things Beginners Must Know About Saving For Retirement
As an example, let’s say it will take you five years to pay off your debt completely.
During that time you could have been contributing $5,000 per year to your employer-sponsored retirement plan, which would also come with a $2,500 employer matching contribution. If all of your money would have been invested in stocks providing an average annual return of 10% per year, you would have $48,232 after five years.
We can think of this as the opportunity cost of paying off debt instead of funding your retirement. As you can see, it’s a steep price to pay, and that’s why you need to seriously weigh the benefits versus the cost of an either/or decision.
To pay off debt, consider debt consolidation
If you do decide paying off debt is something you want to do right now, debt consolidation may be your best bet. It’s a simple process—you take multiple debts and combine (or consolidate) them and pay down that one, lower interest debt.
You can do this a couple different ways: A balance transfer, a debt consolidation loan, or a home equity loan or line of credit are just three of the options we recommend.
A balance transfer involves transferring your debt (let’s say, credit card debt, for this example) to a 0% APR balance transfer credit card. This is the way to go if you can pay off all your debt during the 0% APR promotional period (usually between 15 and 18 months).
A debt consolidation loan is exactly what it sounds like: A loan with the express purpose of paying down debt. Personal loans are a good option because you don’t have to put down any collateral and you can choose from a range of repayment periods and rates.
Finally, a home equity loan or line of credit can help you pay off debt, but only if you own a home. You can use the equity you’ve built up on your home to secure a loan or line of credit to use for debt consolidation. However, this is our least recommended way to pay off debt, since it involves putting up your home as collateral.
The true lesson? Avoid debt as a lifestyle
We can see there is an obvious cost to prioritizing paying off debt. But there is one fundamental reason why you might choose to payoff your debts anyway: to avoid the possibility of debt as a lifestyle.
Typically, people who are in debt in middle age were also in debt when they were young adults. It often happens because debt becomes a bad habit that’s hard to break. And it’s harder still when you consider that debt is often used to pay for a lifestyle that you couldn’t otherwise afford. It’s easier to fall into that trap than you may think.
When debt becomes a lifestyle, it’s almost impossible to get out of it—other than through bankruptcy, or even a series of bankruptcies. You know that this is a possibility if the use of credit becomes an important part of your overall financial life. And once it does, nothing short of drastic action can reverse it.
If you’re under 35, the time to deal with a debt problem is now. Having a well-funded retirement plan will be of no benefit if it is offset by an equally high level of debt.
If you are deep in debt, seriously consider your situation and your options, as well as the implications for your future.
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