Pay Debt or Save?
Should you be focusing on paying off debt or saving for retirement?
The beginning of the year is always a good time to take a look at finances, including paying off debt.
You can use a variety of strategies to pay off debt, but like many people, you may be torn between paying off debt and the need to save for retirement.
There’s no one decision that’s right for everyone, but here are some factors to consider when deciding.
Interest vs. Rate of Return
The most common way to decide between paying off debt or saving for retirement is comparing interest paid to an investment’s rate of return.
For example, say you have a credit card with a $10,000 balance and pay 18% interest. Get rid of those payments and you essentially get an 18% return on your money. An investment would have to return greater than 18% to make that the best choice.
That’s a pretty tough challenge, even for professional investors. And bear in mind that investment returns are anything but guaranteed.
If you make investments rather than pay off debt and your investments incur losses, you may still have debts to pay. By contrast, the return that comes from eliminating high-interest-rate debt is a sure thing.
If your employer matches a portion of your workplace retirement account contributions, that can make the debt versus savings decision more difficult.
Let’s say your company matches 50% of your contributions up to 6% of your salary. That means you’re earning a 50% return on that portion of your retirement account contributions.
If surpassing an 18% return from paying off debt is a challenge, getting a 50% return on your money simply through investing is even tougher. The old saying about a bird in the hand being worth two in the bush applies here.
Very few investments can offer the same degree of certainty. That’s why many financial experts argue that saving at least enough to get any employer match for your contributions may make more sense than focusing on debt.
It’s Not All Or Nothing
The decision about whether to save for retirement or pay off debt can sometimes be affected by the type of debt you have.
If you itemize deductions, the interest you pay on a mortgage is generally deductible on your federal tax return. Let’s say you’re paying 6% on your mortgage and 18% on your credit card debt, and your employer matches 50% of your retirement account contributions.
You might consider directing some of your available resources to paying off the credit card debt and some toward your retirement account in order to get the full company match, and continuing to pay the tax-deductible mortgage interest.
There’s another good reason to explore ways to address both goals. Time is your best ally when saving for retirement. If you say to yourself, “I’ll wait to start saving until my debts are completely paid off,” you run the risk that you’ll never get to that point, because your good intentions about paying off your debt may falter at some point. Putting off saving also reduces the number of years you have left to save for retirement.
When deciding whether to pay down debt or to save for retirement, make sure you take into account the following factors:
-Having retirement plan contributions automatically deducted from your paycheck eliminates the temptation to spend that money on things that might make your debt dilemma even worse.
-If you decide to pay down debt, make sure you create a mechanism that automatically directs money toward the debt.
-If your workplace savings plan allows loans, contributing to the plan not only means you’re helping provide for retirement, but also building savings that could potentially be used as a last resort in an emergency.
-If you need to borrow from your plan, make sure you compare the cost of using that money with other financing options, such as loans from banks or credit unions. Although interest rates may be favorable, the amount you can borrow is limited, and you generally must repay it within five years or even immediately if you leave your job.
- If you focus on retirement savings, make sure you’re invested so your return has a chance of exceeding the interest you owe on a debt. If you invest too conservatively, the rate of return may not be high enough to offset the interest rate you’ll continue to pay.
Regardless of your choice, perhaps the most important decision you can make is to take action and get started now.
Daniel C. Jones is a branch manager and senior vice president for investments at Raymond James. This information was developed by Broadridge, an independent third party and Jones. It’s general in nature, isn’t a complete statement of all information necessary for making an investment decision and isn’t a recommendation or a solicitation to buy or sell any security.
For more information, contact Jones at Dan.Jones@RaymondJames.com or 866-760-3544.
Pay Debt or Save?
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