This is perhaps one of the most asked questions we get at MPower Co. Is it better to pay down debt or save for retirement? The quick answer is both. But keep reading, because there are lots of tips on how to do both in this post!
A Quick Story on Saving for Retirement
Last year we had the opportunity to present to a group of individuals about retirement planning. We always leave time at the end for questions, because we want individuals to walk away with information that they came to the experience looking for.
One gentleman said at the very end that he needed advice with respect to paying for his daughter’s college education. He stated that his daughter was starting college in the next two years and he was planning to access funds from his retirement savings to pay for her education. He was looking for advice on if that was a smart financial decision.
Dr. Thia, MPower Co’s Director of Education, talked him through it, and warned him that depending on his age, which she did not know, he would likely incur tax and penalties for accessing money in a qualified retirement account. Additionally, Dr. Thia encouraged him to look for other sources of funds (his daughter qualifying for aid in the form of grants or scholarships, etc.). There are ways to pay for education; however, no one is going to give you money for retirement.
Finally, she reminded him that taking money out of the account, means there is less money to compound as he nears retirement. Whenever that may be for him.
How to Prioritize When to Pay Down Debt or Save for Retirement
First, let’s talk about saving for retirement. It’s critical that you do this, no matter the amount of debt you have each year, in order to have long-term financial success. The reason, compound interest. Giving your money time to grow is critical.
- Meet the baseline amount of savings in 2021 for retirement, if you’re not already doing so.
There are two prongs to this item. If your employer has a retirement savings vehicle, make sure you are utilizing it. If your employer does not, then you need to open an individual retirement account (IRA) or a Roth IRA and contribute the maximum.
I said this in last week’s post, but it’s so important I’ll say it again. Know what your employer’s match is on your retirement account and make sure you are at a minimum contributing what you need in order to receive the full match. At my previous employer, I needed to put in 10% to get a 6% match. This meant that by doing that every year, I was contributing 16% of my salary towards retirement, while only having what went into my bank account decreased by 10%. Don’t miss out on free money!
If your employer doesn’t offer any incentives, still contribute. My recommendation is to contribute 10% of your income to start.
If you do not have an employer sponsored retirement plan, open a traditional IRA or a Roth IRA. The only difference is how they’re taxed. If you are under age 50, in 2021, you can contribute up to $6,000 over the course of the year. If you are over the age of 50, there is a catch-up provision allowing you to contribute $7,000 to a traditional IRA and $6,500 to a Roth. Make it your goal to contribute the maximum amount to the type of IRA you choose to contribute to.
- Increase your retirement savings.
The previous item was simply the bare minimum recommendations. If you are already doing the minimum, it’s time to take things up a notch.
With IRAs, the contribution limits can be changed from year-to-year, so as the contribution amount is increased by the IRS, make sure to increase your contribution amounts as well.
For employer sponsored plans, I highly recommend that you increase the amount you are contributing each year. So, at the beginning of each year (like now), increase your contribution 1% or 2%. It won’t decrease each paycheck that much, and the small increase in savings can really allow for money to grow over the long run.
Additionally, if you are given a cost of living adjustment or you receive a raise during the year, increase your retirement contribution. You are already used to living on less, so if you get a 3% raise and you increase your contributions by 1%, your paychecks will still increase.
- Critical to Saving for Retirement is Having an Adequately Funded Emergency Fund
The last piece of information related to savings I want to touch upon before turning to paying down debt is related to having an adequate emergency fund. It’s such an important topic, I’ve already written this post about it.
Having an adequately funded emergency fund is what helps us bounce back when life happens. Invariably the dishwasher will quit working right after we replaced the tires on our car. Or we have a water issue (I’m a bit touchy about water issues – we’ve had a couple in our house!) right after we’ve committed money to a summer vacation.
Whatever the case may be, things come up, and in order to keep ourselves from needing to rely on debt instruments to help us get through what comes our way, we need already earned money to fall back on. That is what an emergency fund is for.
Now to Focus on Paying Down Debt
While you are working to save for retirement (or other major goals, like a down payment for a house, etc.), also prioritize paying down debt. There are a few strategies to talk about.
- Make Minimum Payments on Everything
For many of us 2020 was a year of survival, and we may still be in survival mode. That is ok. However, we need to do what we can to make sure we can at the least pay the minimum monthly payment on all lines of debt. The reason for this is to protect our credit score. Missing payments or not paying the minimum payment is reported to credit reporting agencies and lowers credit worthiness.
Credit scores affect the interest rates on loans we may take out in the future – for instance on a mortgage. If you are in a space where you cannot make the minimum payment on everything, you need to assess whether there are debt lines you can pay off, negotiate with your debt service provider (perhaps refinance your mortgage to a lower interest rate to save interest expense – rates are historically low right now), or increase your income.
If you are in a serious place where you feel as if you are unable to pay, reach out to Consumer Credit Counseling Service as they are the top resource for helping you determine appropriate next steps.
5. Organize Debt Details
To tackle debt head on, knowing the details of the lines of debt is critical. Organize your debt information to include information regarding the services provider, the amount owed, interest rates and fees (i.e. if you have a mortgage with mortgage insurance). Having this information organized in one place can truly help you wrap your mind about how to minimize your debt efficiently.
Know how much money it would take to make at the least the minimum on all debt amounts owed each month.
6. Determine in Your Spending Plan How Much You Will Pay Towards Debt Each Month
To pay down debt, we have to prioritize this in our spending plan.
We are so excited in our household; in 2021 it is in our spending plan to pay off the remainder of Mark’s student loans and then by 2023 we expect to have the remaining part of our mortgage paid off. By the end of 2023 we will be completely debt free.
How do I know that we will accomplish these things? Because we have prioritized paying down debt in our spending plan every month since we combined our finances.
I think this point, though, is best made using an arbitrary example. For an individual who has a mortgage, car payment, student loans, and maybe some credit card debt, say the minimum payments on all of those debt lines is $1800 a month. Instead of the spending plan showing $1800 towards debt over each month, putting an additional $200 or $400 towards debt can really minimize interest expense over time. So, instead of $1800 a month going towards debt its $2000 or $2200.
My argument would be to make this feel like a stretch but not so much that your needs aren’t met and you can’t focus on building an emergency fund at the same time. There is a fine balance between paying down debt and putting your life on hold. I encourage you to push the envelope but not miss out on life.
7. Pay Highest Interest Rate First or Smallest Debt Amount First
But where to put the extra $200 or $400 a month? In personal financial planning there are two recommended guidelines for where to put the money.
The first will save you the most interest expense, which means you will pay less overall on your debt in the long run. Put the extra money towards the line of debt with the highest interest rate, making sure to still pay the minimum on all other debt. In the example I gave above I would expect that to be the credit card debt. Once the credit card debt is removed you put the extra money and the payment amount that went towards the credit card on the next highest interest bearing debt. So, in the example, the person is still paying $2000 or $2200 on debt even after the credit card is paid off.
While that saves the most money, there have been studies that show psychologically that going from 4 debts to 3 debts is rewarding. It gives a sense of accomplishment and keeps individuals motivated to pay down debt. So, instead of focusing on interest rate, in this scenario a person would focus on paying down the loan with the lowest value. So, say a person is down to the last $4,000 dollars of payments on their car loan, but the other debt lines are higher than that, the person would pay the minimum on all debt and then put the extra $200 or $400 a month towards the car loan. Once the car loan is paid off the individual would focus on the next debt with the lowest face value.
In each of these scenarios the goal is to have a snowball effect so that by the end, the individual can put the entire $2000 or $2200 towards one debt. That can really chip away at debt.
8. Don’t Replace Debt with Debt
The final message with regards to the conundrum of whether to pay down debt or save for retirement is to not replace debt with debt.
It’s so easy to pay off a car and think, now I can buy a new one; I was making a car payment, so I can make a car payment again. It’s so easy to get caught up in financing a furniture purchase because they’re offering 0% interest. Remember 0% interest isn’t always 0% interest (read more in this post)!
The only way to become truly debt free is to stop going into debt. The goal is to pay for things with money already earned and not with money we plan to earn. This is critical to having long term financial flexibility and setting yourself up for retirement.
Set Goals for Retirement
There was a lot of information in this post about whether to pay down debt or save for retirement! You may have a lot swirling in your mind about how to accumulate wealth for retirement or how to prioritize paying down debt. To help you get what is going on in your mind organized, MPower Co has a Goal Setting Guide that can help you set goals in 30 minutes or less. It will help you find clarity and focus on what you want most. Get your free copy of the guide here!
Richer Retirement Course
If you found this article educational and empowering as you look towards retirement (whether that be in 2021 or 2040), MPower’s foundational course Richer Retirement is for you! This is MPower’s course for individuals wanting to live a rich life personally and financially starting now and through the retirement years. For more information on the course, visit the course page on our website.
The only time that Richer Retirement will be offered to the general public in 2021, begins February 2nd. Registration will be open the week prior to the course. If you want to be notified when registration opens email us at firstname.lastname@example.org or sign up for our Weekly Newsletter and current events here!