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Should You Pay Off Debt or Save for Retirement?

Should You Pay Off Debt or Save for Retirement?

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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?

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Wes Nishioverly simplisticNiyi AdeoshunStuartStevan Dostanic, CFA Recent comment authors
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Damian
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Damian

Yup. Pay off debt. Always!

Daisy
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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.

michael
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michael

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

Jonathan
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Jonathan

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

Brian
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Brian

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.

Stevan Dostanic, CFA
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Stevan Dostanic, CFA

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.

Stuart
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Stuart

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.

Niyi Adeoshun
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Niyi Adeoshun

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.

overly simplistic
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overly simplistic

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,… Read more »

Wes Nishi
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Wes Nishi

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… Read more »

Should You Pay Off Debt or Save for Retirement?

by Kevin Mercadante time to read: 4 min
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