Should You Pay Off Debt or Save for Retirement?

We can all see the benefits of having a large retirement portfolio. If it’s big enough, it can provide you with a standard of living comparable to — or even higher than — the one that you have when you’re working. But let’s face it, not everyone will have a retirement portfolio that will be that large, or even one that will be remotely sufficient. If it looks as if that may be your situation, paying off debt can probably get you a bigger bang for your buck than putting away more money for retirement savings.

debt vs save

Consider the following…

Monthly payment reductions can be bigger than income from the same amount of money

This one is best explained by example.

Let’s say that you have $10,000 that you can use either to invest or to payoff debt. If you invest the money in the stock market and earn the long-term average of about 8%, that will represent an income increase of about $800 per year.

But instead of investing the money, you use it to payoff a car loan with a $300 per month payment and a balance of $10,000. By paying off the debt you reduce the annual expense of your car loan by $3,600, or more than four times the amount that you would earn if you invest the same amount of money.

A car loan is even a bad example, since it will be paid off in a fixed amount of time anyway. But if you apply the same principle to more open ended loan types, such as mortgages and credit cards, the benefit will be more lasting. And that in itself has several advantages from a financial standpoint.

Paying off debt can free up income for larger retirement contributions…

If you payoff debt before retiring, that will allow you to invest more money for your retirement.

For example, in the above example of paying off the car loan instead of investing the money, you will free up $300 each month that can be directed into your retirement savings. And once it is in your retirement plan, it will begin earning you more income.

And naturally, that advantage would be even greater if you were paying off $20,000-$30,000 in credit card debts, or a $200,000 mortgage. The more debt you can eliminate, the more money that you will have available to invest for your retirement.

…and reduce expenses in retirement too

The “B side” of paying off debt is that by doing so you’ll also reduce your expenses in retirement. Let’s say that your income requirement during retirement is $4,000 per month. Of that amount, $1,600 is debt payment — your mortgage ($1,000 per month), a car payment ($300 per month), and credit card payments totaling $300 per month.

By paying each of those debts off, you will reduce your need for retirement income from $4,000 per month to $2,400 per month — which is a 40% reduction. Yes, you will have less in your retirement portfolio as a result of paying off your debts, but you’ll also have less need for retirement income, which will mean that you will need a smaller portfolio.

This will be even more important when you consider the tax consequences of needing to generate a higher income. Sure, it may be nice to have an income of $4,000 per month rather than $2,400, but the higher income could result in higher income taxes that would reduce your net income. It may even trigger more of your Social Security income being taxable.

It works especially well if you’re approaching retirement and don’t have enough retirement assets

If you’re in your 50s or early 60s and it’s pretty clear that you will not have a large enough portfolio to cover all of your living expenses by the time you retire, then paying off your debts will probably be the better strategy for you. Paying off debts often provides more bang for the buck than an equivalent of money invested for income — for all of the reasons discussed above.

Paying off debt works even better during bear markets

There’s a hidden bonus to paying off debt rather than investing the extra money in retirement savings.

When you pay off debt you get a permanent reduction in your expenses; when you invest money in the stock market, your income is never guaranteed.

Simply put, paying off debt provides a guaranteed cash flow, that investing cannot match.

This is never more true than in bear markets. Paying $10,000 to eliminate a car loan with a $300 per month payment eliminates an entire expense. If that same amount of money is invested in the stock market — and stocks fall significantly — that $10,000 could turn to $5,000 in a matter of months. At that point, you would be wishing that you had paid off the debt instead of investing the money in the stock market!

In a perfect world, you would both payoff debt and invest more money in your retirement portfolio. But if you have to make a choice — and many people do — paying off debt is probably the better of the two.

The reason is simple: paying off debt is a sure thing — investing money never is.

Have you ever agonized over the choice of whether to invest a certain amount of money in your retirement portfolio or use it to payoff debt?

About the Author

By , on Mar 25, 2013
Kevin Mercadante
Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

Leave Your Comment (20 Comments)

  1. Wes Nishi says:

    I think anyone can agree that if you have credit card debt, pay that off first. However, if you have say a 4% fixed-rate mortgage as your only debt, the question is trickier. I think the better advice is that if you are questioning whether to invest or to pay off debt in this situation, pay off debt. At the very least, you’ll know that reducing your interest costs is guaranteed.

    I think one way to think of paying off a debt is that it kinda like a tax-free investment. If you were to gain 7-8% on a mutual fund non-registered, you would pay capital gains and dividend taxes. If you were to pay on 7-8% on a consumer loan, the interest savings are not taxed.

    • Kevin Mercadante says:

      Hi Wes – The tax free return factor with debt payoff is highly underrated. I think of paying off debt is without a doubt the more “sure thing” or at least as much of one as you can get anywhere.

  2. overly simplistic says:

    The post is full of errors and omissions.

    For example, the car loan sample didn’t state the posted borrowing rate. For simple demonstration purpose, if the car loan is 0% financing, the example above makes absolute no sense. Paying off principle is different than reducing risk of over leveraging.

    An other example of paying down the mortgage during retirement. For many people, there are number of option if you don’t already payoff the mortgage at retirement. A) reverse mortgage, B) refinancing with different amortization, C) downsizing.

    I think anyone who seek financial advices, better not take this artcle seriously. Instead, go seek a financial advisor for a proper consultation.

    • Kevin Mercadante says:

      For that matter, anyone who plans to do anything should speak with a financial advisor. A blog post is just a starting point, a place to post ideas. When you get serious, you have to consider how the suggestions will impact you based on your own circumstances.

      But for the record, advising people to get out of debt is never a bad idea – except to a lender who has an obvious vested interest in keeping people in debt :-)

  3. Niyi Adeoshun says:

    If we take in consideration the fact that every investment has an element of risk, we will get rid of debt first. You cannot afford to lose money while you still have debt to pay. If you pay your debt first it is off forever and then you can use your income to invest – if you wish.

  4. Stuart says:

    This article is simplistic and fails to furnish any proof of the “debt is bad” position being adopted. In the summary, the comparison is drawn between expense saving of paying down debt versus potential for short term compression of capital if the sharemarket falls 50%. The reality is that the same portfolio of stocks would continue to yield 3% income on the original $10K investment, regardless of what prices do. It’s irresponsible to be publishing this type of facile and slanted analysis on the web.

    • Kevin Mercadante says:

      Hi Stuart – It’s a different approach for people who may have to make financial choices in retirement. I consider it to be irresponsible to recommend that everyone should be in the stock market at all times, even approaching retirement.

      Also, I never said “debt is bad”, but I am of the opinion that debt and retirement are not compatible – I hope you see the validity of that position.

      And in my humble opinion, a 3% return on a stock portfolio is no consolation for losing 50% of your capital in a crash. A retiree can’t absorb that kind of loss, especially if they have substantial debt.

  5. Stevan Dostanic, CFA says:

    Excellent piece!

    As a rule of thumb, you should aim to enter retirement completely debt free. The flexibility this provides will be worth the short term gain. However, I agree that it is easier said than done for some.

    Also, be VERY weary of individuals that counsel you to borrow for the purpose of investing (as you near retirement).

    Very popular sales tactic for Canadian Banks. They make money on the loan and make money on the management fees (MER) of the investments they buy with the borrowed funds.

    • Kevin Mercadante says:

      Hi Stevan – I think that’s really the take away, that you should make a priority of paying off debt before retiring. It’s a personal choice of course, but life is easier without debt.

      In my work I see those management fees, and can’t believe that people pay them. They turn a 8% return into 4%. Better than bank investments, but not worth the risk.

  6. Brian says:

    You are forgetting one thing with the argument of making 800 bucks a year: compounding.

    Right now my mortgage rate is low that I’d rather invest. If rates were to go up, I could sell my equities and pay down debt. Of course it is riskier this way, but such is life.

    • Kevin Mercadante says:

      But remember Brian, we’re talking about retirment here. The 8% return on stocks isn’t guaranteed (nor is the principal for that matter), but the monthly payments on the debt are.

      If you’re at least 20 years away from retirement you’re doing the right thing keeping the mortgage and investing. You’re mortgage will likely be paid off by the time you retire and you’ll still have your investment portfolio.

  7. Jonathan says:

    Totally agree that paying down debt is critical. It is a difficult balance, especially with a large mortgage but the more you can pay down the easier life is when your income drops, which it inevitably will do

  8. Hi Daisy–I’m in the camp who believe that paying off your mortgage before retirement is a must. If a mortgage is tough to juggle when you’re working, it will only be worse when you retire. I should be high on the list of debts to be eliminated, even delaying retirement untit it is.

    Hi Michael–Even if there’s a cash flow benefit to paying off your home equity line with a 401(k) loan I would recommend avoiding it. A 401(k) loan is like taking a margin loan on your retirement account and I think that’s a risk that isn’t worth taking. If you’re plan is primarily invested in stocks, it would represent double risk (stock risk plus the loan). And as Pinyo pointed out, if you leave your job you will be looking at a big tax liability and penalty. The downside is greater than the benefit.

  9. michael says:

    The post was helpful but let me ask a different question. What if its possible to take a loan on 401K to payoff a home equity line of credit. I pay 8.15% interest and that would be $500 a month extra in my pocket. The down side is I would not being write off the interest. Can anyone weigh in?
    Thank you

    • Pinyo says:

      It is a good idea if you are certain that you will not lose your job, or leave your job, before the loan is paid off. If you cannot repay the loan, you will have to pay 10% early withdrawal penalty and taxes on the amount that you cannot repay.

      Another thing to consider is that while you’re repaying the loan, some companies do not allow you to contribute to the plan. So you are taking the tax hit twice — once for not being able to deduct the interest for the home equity, and another for not being able to contribute to the plan.

      On the plus side, any interest you pay for the 401(k) loan will be paid to your account.

  10. Daisy says:

    I think that, unless you can find a VERY high interest investment, paying off debt is usually the way to go. You made some great points, and I also think mortgage debt is good to start paying off more aggressively as well. Retirement is important, but it’s also important to realize what will benefit you the most in the long run.

    • Hi Daisy–You hit the nail on the head with very high interest investments. There are none that will pay higher than you will be charged on debt, at least none that are guaranteed. That’s yet another problem, matching debts with an equivalent amount invested in stocks which are not guaranteed.

  11. Damian says:

    Yup. Pay off debt. Always!

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