Deciding where to direct your money is a tricky thing when you have both debt and an investment portfolio. On the one hand, you know it’s smart to pay down high-interest debts. But you also know you also need to save for retirement.
Should you do both? Can you do both? Which move is the smartest use of your money?
Let’s break this down, since it’s never as simple as one way being overwhelmingly better than the other. With financial planning, you always need to look at your own, individual conditions, numbers and the interplay of your financial realities to pinpoint where you are in your financial journey and which decisions are best.
Interest rates – let’s do the math
Let’s say you have a credit card charging 20% interest on a big debt. Common sense would say that if you’re paying more interest than you’re earning in interest, you’re losing money. With that piece of the puzzle alone, you could say that it would be wisest to direct your money into paying that big debt off, while waiting on your 401(k) contributions.
But what if your 401(k) has a healthy rate of return AND offers a company matching contribution plan?
With a 401(k) match you are getting an instant return on your money. Not putting money into your 401(k) to pay down your credit card debt may seem like a smart choice. But in this case, you are losing out on the opportunity to begin building a retirement fund.
The smarter financial choice is to contribute at least enough to your 401(k) first to get the match, since that’s free money. Even if your 401(k) doesn’t have a match, you should try to contribute to your future retirement needs so that a healthy savings stream can form and build for you.
The type of debt matters
If you’re looking at debts with low interest rates, such as mortgages around 5%, student loans on the lower side, even car loans that you were able to get for at or near 0% interest, it can make sense to direct a larger portion of your money into an investment strategy as you pay off these lower-interest debts with a good and dependable plan.
Now let’s say you have a significant amount of high interest debt, such as those 20% credit cards, and your 401(k) does NOT have a high interest rate, nor a matching contribution. It might be smarter to pay down the debt while still investing a smaller amount of money going into your 401(k).
Another strategy is to find a balance transfer credit card with low or 0% interest for a year. Consolidate all your high interest debts onto that card. Not only will you save the interest payments, you can divert some of that savings into your retirement account.
Logic doesn’t always make sense
For many individuals, it makes more sense to focus on getting out of debt before starting a retirement fund. If you are younger or don’t receive retirement savings benefits from your employer, then you may want to make this choice because it:
- Will free up cash if you don’t accrue other debts
- Could increase your credit score which can help if you are planning on buying a home or car
But humans aren’t always logical. If you wait to pay off debt before saving for retirement but then never manage to pay off the debt, you may get to a point where it’s time to retire and you are completely unprepared.
Best solution – strike a balance
As your totals change in your debts and in your investment accounts, you may choose to change your strategy. Your financial advisor will be right there with you, spotting that ideal moment in your progress to turn the dial and perhaps direct more money into your 401(k) or IRA so that it can take advantage of time to build more wealth for you.
If you are in the position to do so, you should pay off debt and fund your retirement plan at the same time. It is never too early to invest in your retirement so the sooner you can get started the better.
Listen to our podcast here for additional scenarios, as well as our thoughts on what young investors need to think about now. Contact us with your questions or if you’d like to get our experience on your side working for you.