Should You Pay Off Debt or Save for Retirement?

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One of the questions I see a lot deals with which financial goal you should tackle first.

Should you pay off your credit card debt first, and then build an emergency fund? Should you save for retirement while you still have school loans? Which credit card should you pay off first?

Yesterday, Deacon from Well Kept Wallet asked the following question in response to my post on the 2012 Retirement Confidence Survey:

I agree with trying to start investing as early as you can but what if you have debt? Shouldn’t you pay that off first?

My first reaction was to look through the archives here to find articles that cover this topic. I found several–

One thing that I found interesting is how my approach to this topic has changed over the five years I’ve blogged here at the Dough Roller. Today, my starting point would be to prioritize savings and debt repayment. Let me explain.

Recently I wrote about where you should put your retirement savings. Based on a forum posting over at the Bogleheads, the priority looks something like this:

1. 401k/403b up to the company match
2. Max out Roth IRA
3. Max out 401k/403b
4. Taxable Investing

So let’s add some debt into this picture. Let’s assume the following debts:

1. Fixed rate mortgage at 5%
2. Student loans at 3.4%
3. Car Loan at 7.5%
4. Credit card debt at 18%

Now the picture is not so easy. Still, I think we can come up with a general framework on how to approach this, recognizing that every situation can be different and require a different approach. So where do we begin?

Lower Every Interest Rate You Can

Step one with debt is to get the lowest interest rate you possible can. Can you refinance your mortgage? Even at the 5% in our example, a refi down to 4% may be doable, given the low mortgage rates today.

Can you refinance your car loan? It’s actually much easier than you might think. Most auto refinances can be done online. Finally, can you transfer your balances to a 0% credit card? Credit card rates tend to be the highest as compared to other forms of debt, so getting your interest to zero can save a lot of money.

Where do you start?

Let’s assume that you can’t get your interest rates any lower. Where do you start? If I were in this situation, my first step would be to invest in a 401(k) up to my company’s match. Why? The company match is free money. Even with credit card debt I’d take advantage of my employer’s contribution to my retirement. Some may disagree with me on this one, but it’s just too hard for me to turn away free money.

Once I’ve done that, or if my employer doesn’t match 401(k) contributions, I’d turn my attention to a small emergency fund. For me, I’d start by saving enough money to cover my expenses for one month. I just can’t stand the thought of living paycheck-to-paycheck.

Once I had a small emergency fund stashed in a savings account, I’d tackle my high interest credit card debt. At 18%, the cost is too high to ignore. And I’d do everything in my power to pay of the cards as quickly as possible. (If you’re struggling with high rate cards, check out our series on how to get out of credit card debt.)

Once you get rid of your high rate debt, the choices become a bit more difficult. Some would say pay off all of your non-mortgage debt. But at reasonably low rates, I prefer a more balanced approach.

I would take any extra cash (over and above the minimum payments I had to make on my debt) and put it in equal parts toward retirement savings, debt, and my emergency fund. For the debt, I’d tackle the car loan first because it has a higher rate than the school loans. The school loans would come second. And I wouldn’t begin paying more on my mortgage until I was maxing out my retirement savings and a 6-month emergency fund.

The problem I have with trying to pay off all your debt first is that so many people never succeed. The pay down their debt for a period of time, but then something comes along that causes them to go into more debt.

So that’s how I’d approach Deacon’s question. How do you handle debt and investing?

Published or Updated: May 9, 2012
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. Deacon says:

    Thanks for such a detailed response to my question. I personally took a different approach. My wife and I had a combined $52,000 in debt outside of our mortgage when we got married. Once we decided to get pay it off, it took us 18 months until it was all gone. This is what we did (in order):

    1. Created a Financial Game-Plan and stuck to it (aka a budget)
    2. Built a Starter Emergency Fund of $1,000
    3. Then started paying down our debt (smallest to largest)
    4. Started investing 5% of our gross income

    This was a very systematic way to approach so we could focus on one area at a time and feel like we were getting somewhere.

    Thanks again,

    Deacon

  2. Raysa says:

    Thank you, thank you, thank you for this post! So many of my friends ask me about this and so many are lost on where to start.

    I personally agree with your approach. I know the importance of paying down debt, but I wanted to make sure I’d started a plan for retirement and for emergency funds.

    Here’s how I’ve tackled things thusfar:
    1) Started retirement plan with employer (no match; they automatically contribute 7%)
    2) Max out 403b
    3) Maxed out Roth IRA
    4) Set aside at least 3 months-worth of expenses in an emergency fund
    5) Pay off any lingering credit card debt (I tend not to run it up)
    6) Pay extra toward student loans, highest interest rate loans first

    This mix has recently gotten shaken up by the addition of car payments and wedding savings, but I feel good about having taken the time to make sure retirement and the emergency fund were planned for before tackling the debts.

    I’m off to share this! Thanks again!

  3. Justice says:

    My response to people over the years has been to tackle the debt as much as possible. Debt never disappears (unlike many investments the past decade); it must be paid or you wreck your credit score, etc. What many people also fail to consider is the unplanned negative events that happens to someone somewhere every day. Things like disability, sickness, jobloss, divorce, unplanned pregnancy… Debt doesn’t care if any of this happens to you – payup or else. While statistically some of these instances are rare, who wants to be THE statistic.

    This question also arises when people get an unexpected windfall (e.g., inheritance). Financial advisors will try to convince people to invest it (so they get a commission or fee). However, in keeping with my philosophy of attacking debt as much as possible, my approach was to ask if the person would save the payment on the debt to restore the windfall. The answer 100% of the time was they didn’t feel they would consistently save it. We would then put the windfall in a 1 year CD. As the balance on the debt came down, we would take that value of the windfall at the maturity of the CD and invest for retirement. This way the debt could always be paid off with the windfall in the event the previously mentioned unexpecteds happen, but the person was compelled to make payments. Is this approach mathematically superior – absolutely not! But it provided safety and peace of mind and eventually freed the individual from debt.

    • Sunk says:

      We bought a townhouse about 10 years ago that has a first, 2nd, and line. We moved out of town and rented the home. Property is now upside down and currently being rented. It was our home. Nice neighborhood, etc. We bought our current house about 5 years ago, which is now upside down too by at least $100,000. We just refinanced for 25 years and have a 2nd on this one as well. My husband completed professional school and owes over $100,000 in school loans too. We have flood insurance, home insurance, medical expenses including needed surgery, etc. We have been paying all of our bills but can’t get very far in the debt snowball with the amount of debt and if my husband lost his job, we would have to give it all up. After adding up multiple small IRA, Roth, Savings plans, stocks from old jobs, we have $55,000 (5 not vested) in investments. Should we consider cashing in whatever we can and use what is left to pay down one of the second mortgages or pay off the line? I know the normal response is to never touch your investments but most people probably don’t have this much debt to income ratio. We don’t have anything else set up for retirement and will probably need to depend on these houses for rental income? At the current rate, we would own both but in 25 years. Yes, school loans would be paid off then too but that is going to be around 65 for us. We can tighten up a little in the budget but we already don’t go on vacations, own two really old cars, can’t afford IVF we want, etc. Any advice would be appreciated.

  4. jim says:

    Pretty good advice. I especially agree that people should utilize their 401k match as the #1 priority even if they have credit card debt. After that paying off higher interest (>10%) debts is a priority.

  5. Long says:

    I put $10k into an emergency fund, set 401k contributions to 5% of gross income, and max out Roth IRA’s every year. I think it’s important to fund the Roth IRA’s because you can’t go back and contribute for years you missed, and the years of compounding add up.

    Everything leftover goes into the debt snowball. After the student loans (only debt besides the mortgage) are paid off, I’ll max out the retirement accounts, fund a small portion of my kids education, and then pay off the mortgage early. Hopefully with enough time to partake in taxable investing.

  6. Stephanie says:

    I don’t think you can overestimate the importance of knowing yourself and your own “Can I sleep at night?” factor. For me, paying off debt has always been important – if I have it, I can’t sleep. The only exception is the mortgage, which doesn’t bother me as long as I can handle the payments, and right now, they are about what I’d pay for rent, so it’s not bad. I’ve gone into debt a couple of times, for good reasons – a really bad streak with virtually no employment, a major international move for a big career boost. Also my husband’s student loans. But each time, we buckled down and worked like crazy and paid everything off. I do need a car, but I won’t even go into debt for that – I am taking transit for hours instead. If I borrowed anything, I could not sleep.

  7. Tony says:

    Great post!

    So….what if all the non-Mortgage debt is at 0%? I transferred my car loan and credit cards to zero percent, and I am very confident I can do this for awhile. I am paying a good chunk on them each month, but I’m wondering how this changes your plan.

    • Rob Berger says:

      Tony, that would definitely change my plan. I would look at how long the 0% offer lasts, how much I’ll owe at that time, and what the interest rate will be. But I wouldn’t be paying off 0% debt beyond the minimum payment. The question is what you do with the extra cash. At a minimum, I’d put it in a high yield savings account to earn interest until the 0% offers expired. If the rates thereafter were reasonable, I might choose to invest the money instead of using a saving account. The nice thing about 0% offers is that it gives you plenty of options. I keep a list of 0% credit cards which you can check out here.

  8. I would say the most important factor in determining whether to pay your debt or invest is the after-tax rate of return that you expect for both of them. For example, if you are paying down student loan debt that is tax deductible and a fairly low interest rate, it would make sense to make the standard payments and invest the rest. Of course, that also depends on how you invest. My dad only invests in CDs because he is still scared of stocks after the last market crash. In that case, it would make sense to pay all debt down before investing, because his investments earn about 0.5%.

  9. Derek says:

    Emergency fund first to avoid more debt and then tackle retirement and debt elimination at the same time, equally. The key component for either is the interest… pay the least you can on the debt and earn the most you can on the savings for retirement. Great post!

  10. I think the obvious choice of having an Emergency Fund first is apparent.
    However, I recently paid off my mortgage (the last of my debt) and preferred to utilize a sinking fund approach whereby I invested the money into a brokerage account holding dividend paying common stocks and ETF’s until I had accumulated enough to fully pay our my mortgage.
    The reason taht I did it this way was to preserve maximum liquidity in the event of a major emergency.
    If I had made extra payments along the way, i still would have had a monthly payment until such time that I paid off the mortgage in full… and I would have been less liquid.
    Investing the extra money with the goal of paying it all off in one shot kept me liquid and also gave me the benefit of eliminating the payment from my monthly cash flow once and for all.
    Yes, I accepted more risk by investing the money in the stock market and paid more interest on my mortgage than I had to by not making extra payments when I had the money. However, the only tangible benefit to your budget comes when the debt payment is eliminated completely.

    • Rob Berger says:

      Tyler, very interesting approach. I’ve considered a similar approach, but I just can’t see putting my mortgage money in the stock market. And if I did, I don’t see me selling it in a few years to pay off the mortgage. If you eliminate the stock market as an option, than yields on low-risk investments are worse than just paying down the mortgage.

      • Rob,
        It helps if you don’t think of it as your mortgage money, it is an additional investment that, if/when the returns are there can be used for whatever you wish. Retirement, mortgage etc.

        Also, what you propose leaves you with less liquidity. Which, if you have an emergency fund isn’t a big deal…except how big of an emergency fund is enough? In the worst scenario medical bills could eat away even a year’s worth of expenses, which would be a huge emergency fund by most personal finance standards.

  11. Sunk says:

    We bought a townhouse about 10 years ago that has a first, 2nd, and line. We moved out of town and rented the home. Property is now upside down and currently being rented. It was our home. Nice neighborhood, etc. We bought our current house about 5 years ago, which is now upside down too by at least $100,000. We just refinanced for 25 years and have a 2nd on this one as well. My husband completed professional school and owes over $100,000 in school loans too. We have flood insurance, home insurance, medical expenses including needed surgery, etc. We have been paying all of our bills but can’t get very far in getting out of debt with the amount we owe monthly and if my husband lost his job, we would have to give it all up. After adding up multiple small IRA, Roth, Savings plans, stocks from old jobs, we have $55,000 (5 not vested) in investments. Should we consider cashing in whatever we can and use what is left to pay down one of the second mortgages or pay off the line? I know the normal response is to never touch your investments but most people probably don’t have this much debt to income ratio. Progress is SO SLOW. We don’t have anything else set up for retirement and will probably need to depend on these houses for rental income? At the current rate, we would own both but in 25 years. Yes, school loans would be paid off then too but that is going to be around age 65 for us. We can tighten up a little in the budget but we already don’t go on vacations, own two really old cars, can’t afford IVF we want, etc. Any advice would be appreciated at my e mail. Thanks!

    • Rob Berger says:

      Sunk, what stands out to me in your question is this–”We have been paying all of our bills.” If I were in your shoes, I would not sell my retirement investments to pay off debt. It’s a quick fix that may give you some short term gratification, but it won’t solve your debt problems. If you can pay your bills and put food on the table, I’d leave the investments alone if it were me. I would, however, take any chance I could to increase my income. That’s always easier said than done, but that’s where I’d focus my attention, along with tightening up your budget as you say you can. Best of luck!

  12. Student Debt says:

    I recently finished grad school with about $180k in debt, most of which is at high interest rates (7.75-8.25%). I make enough that I do not get any tax deductions for the huge amount of interest I’m paying on my loans. I can start contributing to my 401k in January (no employer match) and am trying to figure out how to split my money between paying off loans, retirement, and any other investments. Right now, my loans are set up to be paid off in 10 years, and I am making some additional payments when I can. I am 30, have no current retirement savings, no credit card debt, no mortgage (I rent), and have plenty in my emergency fund. Any advice would be greatly appreciated!

  13. Student Debt says:

    I recently finished grad school with about $180k in debt, most of which is at high interest rates (7.75-8.25%). I make enough that I do not get any tax deductions for the huge amount of interest I’m paying on my loans. I can start contributing to my 401k in January (no employer match) and am trying to figure out how to split my money between paying off loans, retirement, and any other investments. Right now, my loans are set up to be paid off in 10 years, and I am making some additional payments when I can. I am 30, have no current retirement savings, no credit card debt, no mortgage (I rent), and have plenty in my emergency fund. Any advice would be greatly appreciated!

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  15. TF says:

    I agree with maxing your opportunity to receive an employer’s 401k or 403b match. I have about $27k in consumer debt in addition to $25k in student loan. We are on a budget, and are aggressively paying the consumer debt each month while it is at 0% to chunk it down as much as possible.

    My questions is should I withdraw $10k in 2013 from my 403b account which has $70k in it to help pay off my consumer debt quicker. I know their are penalty fees and income tax implications but I’m 35 and still have many more years to contribute to the 403b before retirement. Any thoughts?

    • Rob Berger says:

      TF, I wouldn’t take money out of retirement to pay down debt. By the time you pay penalties and taxes, there won’t be much left to pay down debt anyway. School loans should have relatively low interest rates. And your credit card debt is at 0%. Once the 0% offer ends, I’d transfer it to another 0% offer.

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