There are many financial choices on the road of life, and not all of them have clear-cut answers. There is often a raging debate about where to channel your excess income at end of the month: towards saving for retirement or paying off debt. So, when confronted with this conundrum, which path should you take?
The purpose of financial planning is to balance competing interests with limited resources. Like many questions, this one depends on both your financial circumstances and personal preferences.
Maximize Retirement Opportunities
The first choice is to save money for retirement, which is a central pillar of smart financial hygiene. There are a number of savings vehicles which are designed for retirement investments, such as 401(k) plans and Individual Retirement Accounts (IRAs).
For those with a 401(k) plan–especially one that offers an employer match–it would be almost akin to financial malpractice not to take advantage of these employer monies. If an employer offers a 3% match, for instance, if you contribute at least 3% of your earnings to your 401(k), you will in essence be doubling your retirement savings for free. Not doing this would be leaving free money on the table, and even those adamant on getting out of debt as fast as possible would be wise to contribute enough to your plan in order to enjoy these benefits.
It is important to contribute to other retirement plans, even those that are not linked to an employer. Both 401(k)s and IRAs have maximum annual contributions, and it is recommended to invest in them throughout your working career, as you will not be able to place unlimited amounts of funds into these accounts later in life.
Attack High-Interest Debt
The second choice is to pay off debt, though not all debt is created equal, of course. A fixed-rate 30-year home mortgage, a public student loan, and credit card debt all have very different structures, interest rates, and costs.
When considering your obligations, look at the numbers and understand which debts are costing you the most. Credit card debt, which tends to compound daily, can destroy your finances if you let it get out of control. Most would agree–even the save for retirement first advocates–that tackling your wealth-destroying credit card debts should be a priority.
On the other hand, student loans, especially public ones, have much more comfortable repayment structures that privately-offered loans. In some cases, these loans might even be eligible for partial forgiveness or debt relief. Continuing to make these payments over the years–servicing minimal interest rates–probably would not set back your finances significantly.
Similarly, mortgages are usually designed for multi-decade repayment terms because the cost of the asset–probably the biggest purchase most of us will ever make–is so large. Paying off the entirety of this debt first at the expense of investing for retirement would likely only leave you with a few years in the working world to save for your later years. This is simply not feasible for all but a select few.
Whether or not to focus your energies on repaying your debts quickly, or continue servicing them with minimal payments, will depend on the size and interest rates that you are being charged. Getting rid of high-interest credit card debt should be prioritized, even over retirement savings. Other debts–such as mortgages and student loans–do not necessarily need to be.
Finding the Right Balance
The choice between saving for retirement and paying off debt often comes down to your own unique situation. In most cases, the answer is that you should try to do both simultaneously.
There are multiple approaches to paying off your debt, including the snowball and avalanche methods. Making sure to continue inching towards becoming debt free should always be one of your priorities, with requisite line items on your monthly budget.
Similarly, taking advantage of your retirement accounts throughout your working life will help you to be comfortable during your golden years. Aside from the compound interest you will gain over a lifetime of investing, it is difficult to recoup these lost years if you neglect your retirement accounts for too long.
There is no single correct answer for how to balance between past expenses and future obligations. Though addressing both at the same time is generally the prudent move, it is always a wise decision to consult with a financial adviser to help you chart the right course for you and your family.
Conclusion: Economics of Choices
Every financial decision comes with trade-offs and opportunity costs. For example, saving for a down payment on a house in five years means less money for discretionary spending this month.
In a similar vein, there is a trade-off between between paying off debt and saving for retirement. Both of these worthy goals should be at the front and center of your financial planning.
Understanding the necessary balance between these two objectives is the first step in making a plan to tackle them both.
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