Pay Off Debt or Save For Retirement?

One financial decision that most people encounter at some point in their life is whether to prioritize saving for retirement or prioritize paying down debt. Like with most financial decisions, there is no one right answer for everyone. So let's run through a few things you might want to consider when evaluating these competing goals. Keep in mind, this is not meant to be comprehensive, but rather, meant to give you some ideas to think about.

When you may want to prioritize saving for retirement over paying off debt

Interest rate is an obvious factor that comes to mind for most people. If the interest rate you're paying on your outstanding debt is relatively low (let's just say less than 6%), less than what you could reasonably expect to earn in a retirement account over that same time period, then saving for retirement may make more financial sense. Of course, what you earn in the market is unpredictable and very dependent on your unique need, ability, and willingness to take risk. 

Similarly, if the minimum monthly payments on your debts are very low, and not hurting you from a cash flow perspective, then there may not be a rush to pay off that debt. For instance, payment plans for medical bills may accrue little-to-no interest and have very low minimum monthly payments. In this case, putting any extra cash towards retirement versus paying down those medical bills may provide a greater benefit in the long run.

Age, retirement time horizon, and current savings are other factors to consider. If you're older and approaching retirement, but have very little saved away, the sooner you can contribute to retirement, the better. Large contributions to retirement accounts may provide a more secure future for your family then debt payments. However, this of course, must be balanced with amount of debt, required monthly payments, and interest rate on that debt.

When you may want to prioritize paying down debt versus saving for retirement 

Alternatively, if you have debt with very high interest rates (e.g. credit card debt, where interest rates are likely in the double-digits), it probably makes sense to pay off that debt as fast as possible. High interest debts can quickly snowball into insurmountable debt; the longer it accumulates, the more difficult it will be to pay off. 

On a similar note, if your required minimum monthly payments on your debts are very high, that may be another indication to pay off that debt sooner rather than later. For instance, if your minimum monthly payments on your students loans are $500-$600 per month, this is likely hurting you from a cash flow perspective, and maybe even prohibiting you from contributing to retirement accounts. In that case, the sooner you can pay off that debt, the sooner you can free up cash flow to then save more aggressively for retirement. 

A low credit score may also be a reason to consider prioritizing debt over retirement. At some point, it's likely that you will need to obtain a mortgage to buy a home, or maybe even get an auto loan someday. If either of these things are in your foreseeable future, you'll need to get your credit score in a solid place before applying (otherwise, rates will be much higher--or worse--you can't get a loan at all). So if you have a poor credit score (<600), paying down debt may be a higher, short-term priority than saving for retirement. 

Find the balance

Regardless of your situation, the key here is to find the balance. These two goals aren't necessarily mutually exclusive. For instance, if your employer matches 401k contributions, you should at least contribute enough to get the employer-match--it's free money!

The power of compounding is another important factor.  Generally speaking, the amount you save between age 25 and 35 is more impactful on your retirement than what you contribute between age 35 and 65. So completely neglecting retirement during those early years, even if you are trying to paydown debt, may not be prudent. So you need to find the balance that works for you. 

If your aggressiveness towards either one of these goals (saving for retirement or paying down debt) is preventing your from establishing and maintaining an emergency fund, then that's probably a sign you need to back off one or the other (or both). As we've learned in 2020, emergencies happen and they can bring a huge amount of financial strain. While we can't know the future, we can do our best to be prepared for it, which is why having 3-6 months worth of living expenses in cash is crucial.

Finally, your personal temperament is a factor to consider. If having any debt at all is keeping you up at night, that may be a sign to prioritize debt. Alternatively, if the thought of NOT contributing to retirement more aggressively is stressing you out, that's an influencing factor. Of course, there is a numbers component to all this, but there is also an emotional component as well, that should not be disregarded. 

My personal experience 

Allow me to share my own personal experience with this. My wife and I both graduated from a private college with a hefty amount in student loans (thankfully, our parents helped us out so it wasn't as much as it could have been). Early on in our marriage, we discussed the importance of paying off that debt as quickly as possible. We didn't want that debt hanging over us for years to come. So we consistently paid significantly more than the minimum monthly payments. However, we did not do that at the expense of missing a 401k match. We always contributed at least the minimum to get the employer-match. We also took advantage of HSAs when they were available and made contributions to Roth IRAs as well. So we prioritized paying down debt, without neglecting retirement savings completely. We found a balance that worked for us. 

As you can see, how you strike this balance really depends on many factors that are unique to your situation. A good financial planner can help you think through these things and hopefully help you put some numbers to this decision.  But if you're even taking the time to consciously think through these competing goals, then you're on the right track. I hope this was helpful in getting you to think even deeper about it.