Paying off debt and saving for retirement are both critically important goals. If you don't pay off your debt, your financial life will eventually be ruined. Debts are particularly nasty because interest means the problem gets worse over time. Over time, debt can result in bankruptcy. On the other hand, failing to save for retirement has dire consequences as well. Not having enough saved up for your senior years can result in an awful quality of life and a miserable old age.
The question, then, is which one is more important. Which takes precedence? Should you pay off your debt or save for retirement? While, ideally, you will ultimately both pay off outstanding debts and save up enough for a comfortable retirement, there is still the matter of which one to tackle first.
Unsurprisingly, which one to take on first depends largely on circumstances. The complexity of financial matters means there are few hard and fast, absolute rules when it comes to how individuals should handle their money. However, there are certainly some general guidelines you should know.
Set Up An Emergency Fund
There's actually a key step that you should take care of before either paying off debt or starting to save for retirement. That is to set up an emergency fund. Emergency funds are enormously important. The possibility of a sudden major expense cropping up is always present. You have to be prepared for such exigencies as a surprise medical bill. Job loss and car wrecks can also mean you need to rely on an emergency fund. You should aim to have between three and six months' worth of salary in your emergency fund.
Make Minimum Payments On Your Debt
How much of the debt you owe you should pay off versus how much you should invest for retirement can be tough to determine. However, most debts have a minimum amount you must pay per month. Paying this minimum, as the word 'minimum' suggests, is the least you can do without getting into serious trouble. Penalties such as late fees will generally accrue if you do not meet the minimum threshold. Avoid major financial distress by always making minimum payments.
Evaluate The Debt You Owe
Different debts have different interest rates. Certain types of debt are generally more damaging than others. Credit card debt, for example, is especially harmful. Credit card debt usually has an interest rate of at least 15% APR. At this appallingly high rate, you are on your way to financial devastation. Any debt you have with such high rates must be paid off as quick as you can. Go through all the debt you owe and resolve to tackle the debts with the worst interest rate starting immediately.
Prioritize Retirement Saving Over Low-Interest Debts
Now you know what to do with those high-interest rate debts: pay them off. But what about debts with much lower interest rates? For example, direct unsubsidized graduate student loan debt interest rates are currently below 5%. While the average mortgage interest rate varies enormously over time, it is at present at a very low rate. If you owe debts of these sorts, there is no need to hurry to pay them off.
That's because when you are considering whether to invest money for retirement or to pay off a particular debt, what you are really comparing is the interest rate on the debt versus the expected return for the investment. If the interest rate for debt is lower than what you can expect to get from investing in the stock market, it makes sense to invest money for retirement first.
Now, stock market returns can, of course, vary wildly. Sometimes, the market even goes down for extended periods. However, if you are investing for retirement, you are in it for the long haul. That means that when comparing a debt to the possibility of investing for retirement, you should use the average annual return over the decades, which is roughly 10%. Use this value and your individual circumstances to evaluate whether to put money towards your debt or your future retirement first.