Most financial planners recommend you begin saving for retirement as soon as possible. They have an excellent point too, after all there’s the time value of money that has greater impact the sooner you begin. But let’s step out of the box of conventional thinking for a moment, and consider the possibility that you may be better off paying off debt before saving for retirement.
As a practical matter you may ask, why not do both – payoff debt and fund retirement savings? If you have the resources to do both, that is certainly the way to go. But since most people are dealing with limited resources, there’s a lot to be said for concentrating your efforts in a single direction at one time.
Let’s take a look at the reasons for paying off debt before saving for retirement.
Eliminating payments makes more room for savings
The most basic reason is that by paying off debt, you eliminate monthly payments, and that allows you to put more money toward your retirement savings. By doing this, you are supercharging your retirement savings – you are able to contribute far more than you could if you are trying to juggle debt payments and retirement contributions at the same time.
As an example, by paying off a $6,000 credit line with a $200 per month payment, you will free up an additional $2,400 for retirement contributions each year (12 X $200). If you have several debts, you’ll be able to easily see the huge impact that paying them off will have on your retirement.
Guaranteed rate of return
This is a point that is made in any discussion of paying off debt. If you have a 10% annual rate on a credit card, if you pay the card off completely, you are effectively locking in a 10% rate of return on the money used to payoff the debt. There is virtually no way to get that kind of return – on a risk-free basis – in any kind of investments that can be found in a typical retirement account.
In addition, if you’re investing money in your retirement account with an overall rate of return of 6%, while paying 10% on debt, you are locking yourself into a money-losing situation. The return that you are earning on your retirement investments is not covering the cost of maintaining an equivalent amount of debt.
There are more income options when you’re debt free
One of the single biggest factors that determines your success with retirement savings is the amount of income you earn in your occupation. That will determine the amount of contributions that you are able to make toward your retirement plan. It stands to reason that you’ll be able to contribute more to your 401(k) plan if you earn $100,000 per year than if you earn $50,000.
But debt can often get in the way of your attempts to earn more money.
It’s not unusual for people to decide against taking an out-of-town transfer or starting a business because they have too much debt. The career changes could result in significantly higher income, but debt serves as an anchor keeping you from making a move that could increase your income. This is especially true in the case of self-employment. Having your own business poses certain inherent risks, and all are magnified when you have a lot of debt.
The X factor: a prolonged slide in stock prices
There is one other compelling reason to payoff debt before investing for retirement, and that is the potential for a prolonged slide in stock prices.
If you’re attempting to both fund retirement and payoff debt, but the stock market is falling, you’ll be losing money in your retirement account while you are trying to payoff debt. That can make you feel as if you’re not making any progress at all. After all, while your debt balances are falling, so are your retirement investments!
If you’re paying off debt, you’ll be reducing your balances on a dollar-for-dollar basis. But it is possible for a negative trade-off to occur with retirement savings – you could get $.50 on the dollar on the money you are investing if the stock market is not moving in a positive way.
By paying off debt, you clear the way to make a much greater effort at retirement savings. No, you won’t get as effective a benefit from the time value of money (assuming stocks are rising), but you will have an opportunity to save a lot more money, earn more money, and to avoid an uncooperative stock market by concentrating on one financial effort at a time – paying off your debts.