As people begin to think about retirement, a common question they ask financial advisors is whether they should concentrate on paying off their debt or putting aside money for retirement. The answer is not the same for everyone. Primarily it depends on:
- What kind of debt you are carrying and
- What system motivates you.
Many American between the ages of 65 to 74 — in fact two-thirds of us — have debt. The median household debt for those age 65 and older doubled in just the 10 years spanning from 2001 to 2011. So, determining how to handle our debt in relation to saving for retirement is critical.
It’s difficult to escape debt entirely, and many of us still have mortgages as we enter retirement. But mortgage interest rates are usually much lower than the interest of other types of debt. High-interest debt, such as credit card debt, is the most likely to eat into the quality of our retirement years. It does us little good to enter retirement with some savings if we are using much of it to pay off high-interest debt.
- So, should I pay off all my debt before I save for retirement?
- Some Basic Tips on Debt vs Retirement
- Approaches to Paying Off Debt Before Retirement
- How to Save for Retirement
- Figure Out How Much to Pay Toward Debt and How Much Toward Retirement
So, should I pay off all my debt before I save for retirement?
Some experts recommend paying off all your debt (except perhaps a low-interest mortgage) before you even think about saving for retirement. But most recommend that you pay off debt while at the same time putting money aside for your retirement.
As we discussed in our recent article, Retired and Filing Bankruptcy? Your Numbers Are Growing, one third of those over age 50 say they have used credit cards to finance daily expenses. It’s just too tempting as we pay off debt to start accruing new debts, and once we reach retirement, if we did not put money aside, that can leave us with nothing but debt. This is a good reason to contribute to your retirement as you pay down your debt.
Of course, on the other hand, it does us little good to build a retirement nest egg and then drain it to pay high interest loans and credit cards after we retire. For most people, the trick is to figure out the best way to pay down your debt while adequately contributing to your retirement at the same time. There is no one answer. After considering your situation and your options, though, it is important that you form a plan and stick with it.
Some Basic Tips on Debt vs Retirement
Although financial planners may disagree on some things, most will agree on these two basics:
- If you have an employer who will match your contribution to a retirement up to a certain amount, it only makes sense to put at least that much into your 401(k). Otherwise, you are just throwing away money.
- Set aside some money for an emergency every pay period until you have a buffer against emergencies, such as unexpected medical costs or job loss. Three months is the bare minimum, but you should really have six months’ living expenses put aside. Nine months is even better.
If there is anything true in life, it’s that you need to expect the unexpected, and that could come tomorrow or after you retire.
Approaches to Paying Off Debt Before Retirement
In order to get out of debt as quickly as possible while still contributing to your retirement plan, follow these steps:
- Keep all your accounts current by at least paying the minimum on all accounts.
- Put money aside for your retirement plan (more on that later) and emergency fund.
- Anything left after what you have budgeted for your living expenses goes to the highest interest rate debt until it is fully paid off. This will probably be your credit cards.
The approach of paying off your highest-interest debts first can save you thousands of dollars. Let’s assume you have $5,000 in credit card debt at an annual 19% interest rate. If you are paying $100 per month on that debt, it will take you eight years to pay it and cost you close to $5,000 in interest. But if you pay $150 per month, you can pay it off in two years at around $2,160 in interest. Quite a difference at only $50 more per month!
An Alternative Approach: Reward Yourself with Small Successes
Although it’s logical to pay the debt with the highest interest rate first, some people find it more motivating to pay off debts with small balances before tackling the others. It helps motivate them when they see that they have paid off a debt completely and can put it aside. And after all, it’s critical to stay motivated about paying off your debts and saving for retirement.
How to Save for Retirement
Few people understand how savings for retirement can grow exponentially over long periods of time. Most people mistakenly do a mental linear calculation. This leads them to underestimate their account balance at retirement by a large amount. Because they don’t understand how money grows over time, they often wait to start saving for retirement, which can cost them thousands.
Here’s a very simple example of how contributing a little bit monthly for a long period builds your retirement income:
Say you invest $1,000 every year for 10 years and get an annual return of 10%. When trying to determine how much that will give them after 10 years, many people perform an incorrect linear calculation. They figure that $1,000 invested every year for 10 years at 10% interest will give them $11,000. This is wrong. Taking compound interest into account, the actual amount you have after 10 years is $16,000, not $11,000. The point is that it pays to start saving early, and it’s hard to catch up if you don’t.
Set a Concrete Monthly Goal
It can be difficult to save for an event that seems far away and hard to imagine. Many of us simply can’t wrap our minds around retiring or really anything at all that’s 20, 30 or 40 years away. That means if we don’t set up a structure, saving for retirement is unlikely to happen. You need to know how much you should be setting aside each month to meet your retirement goals, and have it set aside automatically.
Figure Out How Much to Pay Toward Debt and How Much Toward Retirement
Before you determine how much to set aside for retirement on a monthly basis and how much you should pay over the minimum on your debts, you first must know how much you have to work with. Add up your minimum monthly payments for each debt and then subtract that from the amount you can use for your financial priorities after living expenses and other necessities. You can opt to pay all the available money toward reducing debt (as described above) or pay part toward debt and part toward retirement as we recommend.
When deciding on the ratio you pay into each bucket, consider your age and when you plan to retire, the amount of your debt and the interest rates on your debt. Although using a retirement calculator can help, if the answer is not obvious — and for many of us it isn’t — you may want to consult with a financial advisor.
Here is a consideration when debating whether to pay off a loan or make a retirement investment. If you are paying 7% interest on a student loan, you know by paying that off, you will get a 7% return on your money because you will not have to continue to pay 7% interest. If your retirement investment cannot beat that rate, it may be better to pay off the loan. Better, that is, unless you take out a new loan for something else, because you now have more available credit.
However, if you are older, say in your 50s, you may still want to put something aside for retirement, because as we have seen, time is the biggest factor in increasing the value of your investments. A financial planner interviewed by Forbes advises paying off all debt above 6% before saving for retirement, but after that, put most of your money into your retirement plans instead of low-interest debts. You and your financial planner, however, should analyze your own financial situation and retirement goals in order to come up with the best plan for you.
If you are struggling with debt, we may be able to help. Contact Borowitz & Clark today for a free consultation.