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.
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?