Should you pay down debt or save for retirement?
Like many finance questions, I think the answer to this question is: it depends. In the following post, I designed an experiment to test my guess that it is better pay down high interest debt fast, but it might be better to invest if you only have low interest debt. (Spoiler- you can create conditions for various debts where it is better to invest then eliminate debt aggressively.)
The Federal Reserve issued its average American’s debt report for Q3 2016 with the following results:
We know debt is bad for our financial health and that cuts are necessary to eliminate it. Should cutting retirement savings be an option?
As I approached this issue, I hypothesized: for high interest debt, like a credit card at 18%, it would be better to payoff debt than invest for retirement. Conversely, for low interest debt, like a 4% Student loan, it would pay off to invest for retirement while also paying down the loan.
The following experiment takes one $10,000 loan.
- The loan was assigned interest rates from 20% to 4%, in increments of 2%.
- Interest is compounded monthly.
- Minimum payments assigned as:
- $400 for the 20% – 12% loans
- $350 from 10% – 8%
- $250 for 6% – 4%.
Our indebted guinea pig, Ed, has $1000 after all other expenses to pay the minimum on his debt and/or invest for retirement.
Ed decides his investment will make between 4% to 7% over the next 5 years. These figures are fair projections based on current market yields. Should he invest, or aggressively pay down the debt?
- We will hold Ed’ salary constant (no ability to pay more or less)
- market fluctuation (the market will make 4% or 7% each year with no fluctuation, i.e. 1 simulation)
Here are his results, in tabular form. The excel file with all data is here.
The first thing we will see is by applying his entire $1000 towards debt, Ed gets out of debt much quicker than if he paid the minimum, in all cases. He also avoids paying between $1500 and $400 of interest.
Our “Investment Difference Ratio” (IDR) tells the rest of the story. The IDR was calculated by dividing the results of money invested after paying off the loan aggressively by the results of money invested while also making only the minimum payment.
Here’s an example, using the 18% loan’s excel file
For the high interest debt, mimicking a credit card, Ed was much better off paying down his loan first and then investing, regardless of whether the investments returned 4% or 7%.
As his interest rate decreased, however, the IDR tells a murkier story. As the IDR approaches 1.0, it is no longer clear if either strategy is better.
For one loan group, the IDR is less than 1.0. This shows that, under these given set of circumstances, Ed would have been better investing and only paying the minimum on his debt.
These IDR are not hard and fast rules. My experiment ignores interest saved by paying down debt quickly, interest which could be reinvested. It also ignores the fact that small differences in minimum payments and additional amounts invested can yield different results.
The fact that the IDR is not always greater than 1.0 suggests to me that there are times when paying down debt, exclusive of retirement savings, is not always a better strategy than investing for retirement simultaneously with debt pay down. There are scenarios you could create where you might be better off investing than paying down debt!
That sound you hear is the FI community collectively gasping.
In general, it seems that as your expected rate of return approaches the loan’s interest rate, its best to invest and pay down debt. Said another way, saving for the future should not be dismissed out of hand if you have debt.
If you have a large amount of debt with a high interest rate, your math (Rule 1) may reveal that it is beneficial to curtail your retirement savings until you can get your personal IDR close to or below 1.0.
What can You do?
If you have debt and money to pay more than the minimum or invest:
- establish a small emergency fund
- If your employer offers a 401K or 403b matching contribution, ensure you are contributing at least this amount. It’s the only investment guaranteed to double your money!
- Eliminate bad or usurious debt, i.e. payday loans, etc. Remember, in the military, indebtedness and failure to pay may impact your security clearance and your job. Now is not the time to save for retirement.
- Calculate how long it will take to aggressively eliminate your debt.
- Calculate how long it will take to pay down debt with just the minimum payment.
- Determine your level of risk: what % return might you get over the life of your loan if you also invest.
- Answer the following questions:
- Do I need to eliminate the loan because it is causing a bad credit score? (ex., high debt to income ratio)
- Would eliminating the loan lower my credit score? (ex., no debt utilization)
- Am I close to retirement, should I be saving and deal with my debt later?
- Will I get a raise and be able to pay more soon?
- Can I handle paying the extra interest if I decide to invest?
- Do I need to explore other options, like bankruptcy?
Your financial situation is yours alone: you owe it to your family to seriously examine how you are approaching your debt payment and retirement savings.
Practice what I Preach
I ran the numbers for our family. Our weighted average interest rate is fairly low, about 3.5%. Our current investment to debt pay down to minimum payment ratio is about 44:17:7. For every $7 in minimum payments, we pay an additional $17 on our debt, and invest $44. This has changed significantly as our debt has dropped from $107,000. By comparison, Ed’s ratio was either 6:0:4 or 0:6:4.
Using a series of scenarios, I found that by overpaying our minimums as much as we are, we are sacrificing a small but significant amount of investment gains. The numbers suggested we were overpaying by about 40%, assuming a 4% return. The IDR was about .984, suggesting slightly better results by investing now, rather than strictly eliminating debt now with more investments later.
Because we feel strongly about eliminating our debt sooner than later, we decided to continue our outsized payments until after our tax refund, and then reduce our debt reduction by 20%. This reduction only extends our repayment by 3 months, but may result in thousands of investment gain. The new ratio will be 48:13:7. I’ll let you know how it turns out!
Would you sacrifice retirement saving to eliminate debt?
Disclaimer: I am not a licensed financial counselor of any sort. The opinions contained here are my own. Investing has implicit risk, past gains are no guarantee of future returns. You may lose money, including the principal. Not endorsed by the USG or Military.