How to Pay Down Debt While Saving for Retirement
Many Americans have credit card, mortgage, student loan and other debt, which often claim a significant portion of their paycheck. Debt payments can make it especially difficult to save for retirement and begin building a more financially secure future.
"It's really critical that people not just focus on the one side of paying down debt, but also focus on accumulating some sort of retirement benefit," says Sharon Smith, a vice president of investments for Wells Fargo Advisors. "It is becoming evident that Social Security isn't going to be an adequate source of income for most people on its own. We really need to make sure that people are putting money aside for their own retirement."
Eliminating debt and saving for your future at the same time may be ideal, but it's not a feasible scenario for everyone. Here are a few steps you can take to determine an appropriate course of financial action and avoid becoming overwhelmed by the paying-versus-saving conundrum:
Look at the big picture. "Looking at things comprehensively is the first and best decision that someone can make," says Dickinson Miller, a private wealth adviser with Ameriprise Financial. Before deciding whether to pay or save, or how much money to allocate where, evaluate your cash-flow situation and establish a spending plan. "It is important to balance both sides of [your] balance sheet," Smith says. "Go through it, and be like a crime scene investigator. Really examine where you are spending your money, what you've got coming in and what you've got going out."
A budget will not only help you figure out what you can afford to save for retirement, but also how much you can allocate to remaining debt. Further evaluation may also show that you can pay off debt sooner than expected, says Jana Castanon, community outreach coordinator for Apprisen, a national nonprofit credit-counseling agency.
"I can't tell you how many times people come in, working on taking out a second mortgage, trying to consolidate their debt, but they haven't changed their spending habits," Castanon says. "Create that spending plan, and work on paying more than the minimum payments towards those credit cards as well as putting some away for retirement. It's more important as you get older to make sure you keep that debt under control." Once you determine how much money you have to work with, the next step is evaluating the pros and cons of your potential payment and saving options.
Prioritize debt. If you are faced with debt, regardless of the amount or type, there are certain obligations and deadlines you will need to meet. "Regardless of what the collecting organization is, they will tell you to pay up," Miller says. "There will be a minimum amount needed each month, and there is no way around that. You will have to account for that."
Certain types of debt are worse than others, and the sooner high-interest debt can be paid off, the better. "Credit cards are the worst in my opinion," Smith says.
Credit cards vary, but their repayment should generally be made a high priority. "If you've got a 25 percent interest rate on your credit card, you've got to try to get rid of that as fast as possible because that is going to be terribly burdensome," Miller says. "You should address the higher-interest debt more aggressively than the lower-interest debt."
Mortgages are a form of debt that could be ranked as a lower-repayment priority. "A mortgage is good debt in the sense that for most of us, we don't have the cash to buy our homes," Smith says. "The government currently allows you to write off the interest on your mortgage so you are getting an additional break there." Mortgages allow you to build solid equity, and compared to other types of debt, their interest rates are not only deductible but also tend to be more manageable, Miller says.
Similarly, student loans, whether they are taken out by parents or the students themselves, are also considered a "better" form of debt, compared to high-interest credit cards. "It is really important for parents to not sacrifice their future retirement for their children's education, so debt that they incur for educational loans can also be viewed as good," Smith says. "Typically, these loans offer advantageous rates, and sometimes they are not required to begin payments until after the education has been completed."
Car loans are a variable debt, according to Smith and Miller. If the loan has a low-interest rate or other incentive, and you need a car for everyday purposes, it could be factored in as a monthly budget item and not considered high-priority "bad" debt. However, "Remember there is not an absolute difference with debt, as it depends on the loan and where that loan comes from," Miller says.
Weigh the options. So how much of your discretionary income should go toward paying down debt? Should you split it evenly between paying debt and saving for retirement? "It's important to emphasize that it has to be tailored to your situation, but you can arrive at a number by looking at things step by step," Miller says.
Traditional individual retirement accounts and employer-sponsored 401(k) retirement plans can both be quality tax-deductible savings options, but you need to weigh the plan benefits with the costs of your debt. "For example, a 20 percent interest rate on a credit card that is not at all deductible is a really bad thing to have," Smith says. "On the other hand, earning a 7 percent rate of interest on an IRA, in a taxed-deferred account – meaning the after-tax return is even higher – is very valuable." In that situation, your best option may be to resist investing in an IRA plan, and pay off the expensive debt first.
However, depending on the amount of the credit card debt, you could potentially save and pay down debt at the same time. "You could set up an aggressive payment plan, and don't forgo contributing to the IRA. You instead forgo doing things like buying Starbucks coffee for a while, or some of the other things that you do in your life that are really extra," Smith says.
If you were to pick one savings fund to contribute to while working to pay off debt, Smith suggests taking advantage of a retirement plan offered by your employer, like a 401(k) with company matching benefits. "Put just enough into the company 401(k) to get the full match, and then use any leftover money to pay off debt," Smith says. "Check with your human resources department, and find out what benefits your company offers."
A common 401(k) employer matching contribution is 50 cents for each dollar the employee contributes, up to 6 percent of their pay. "That generosity should be taken advantage of to help you reach your retirement goals," Miller says.
Utilize available resources. Similar to how a personal trainer can keep your fitness goals on target, a financial planner can help make sure you are financially on track, Smith says. Organizations such as the Certified Financial Planner Board of Standards and the Financial Planning Association can be good tools for those looking to develop a plan to pay down debt. "Often people don't reach out to get help until there is a crisis," Castanon says. "Set up an action plan early on so [you] can set goals and start working towards [them]. And never think 'I'm too you young, or too old, to save for retirement.'"