This is a common question posed to financial planners and advisers: “Should I save more for retirement or pay off debt first?” Even well-known personal finance pundits disagree on this one. Mathematically, this is a fairly simple question to answer. Behaviorally, however -- actually taking action and sticking with the plan – approaching this question can be much more difficult.
Let’s assume you sat down recently and reviewed your monthly budget. During that exercise, you were happy to discover that you have a couple hundred “extra” dollars available each month. You now face the happy dilemma of deciding what to do with those dollars. Your basic options are simple, of course. You could spend it, you could save it, or you could pay off some debt.
What the Experts Say
As I mentioned, even seasoned financial pros disagree as to the exact approach to take when deciding between paying off debt or contributing more to retirement savings. What we all agree on, however, is the importance of having and staying with a definite plan to pay off expensive consumer debt in a timely fashion. For example, personal finance radio personality Dave Ramsey recommends not even bothering with retirement savings at all until you first pay off allconsumer and student loan debt (but it’s okay to carry a low-interest rate mortgage). Once you become debt-free, he then suggests redirecting 15% or more of your income toward retirement savings. Almost every other personal finance expert recommends more of a balanced approach, such as:
- Contributing to your employer’s retirement plan at least up to the percentage they will match.
- Regularly setting aside cash into an emergency fund every pay period.
- Paying off consumer and student loans, either in descending order according to interest rate or ascending order according to balance (i.e., pay off the small balances first).
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The Mathematical Approach
If the purity and logic of a straight mathematical approach appeals to you, then the solution to the debt vs. savings dilemma is probably fairly clear. Do both. Contribute at least up to the maximum matched percentage in your employer’s retirement plan. This will capture an instant and guaranteed return on your investment, and you won’t feel as if you are missing out on a benefit by not participating. (If you prefer a side-by-side comparison, CalcXML provides an online calculator to help you compare the after-tax return on investing with the after-tax cost of debt.)
With respect to your debt payments, the strategy is also quite straightforward. Pay the minimum required monthly amount on all debts to keep them current, of course. All available additional dollars from your budget (after retirement plan and emergency fund contributions) goes to the highest interest rate debt until it is fully paid. We call this the DebtBlasterapproach, and it is by far the quickest way to eliminate your debt.
However, it may not be the most satisfying from an emotional or psychological perspective. Consequently, there is the risk that you may not stick with it long enough to fully get yourself out of debt. If this could be a concern for you, read on.
Psychology of Debt Repayment
According to recent research conducted by Alexander Brown and Joanna Lahey of Texas A & M University and published in the Journal of Marketing Research, the purely mathematical approach to paying off debt may not be the best approach for everyone. Paying off the smaller balances instead, regardless of the interest rates being charged, seems to provide greater motivation toward sticking with a debt repayment strategy. Mathematics aside, what you do or don’t do ultimately determines your success or failure. Intuitively, most of us understand that breaking up a large task into smaller bites makes it easier to accomplish.
The same is true when it comes to getting out of debt. Maybe Dave Ramsey is onto something with this approach. Consider going for the short term win and the relatively quick sense of satisfaction to fuel your motivation toward paying off all your consumer debt.
Psychology of Saving for Retirement
The psychology behind successfully saving for retirement is a bit more complex. Unless you are far along in your career, retirement can seem far away and abstract. This adds more urgency to immediate needs and problems like getting out of debt, paying for the kids’ college, or buying a house – all goals with more immediate gratification tied to them. Furthermore, people often struggle to fully understand how compound growth works, which leads us to underestimate how much our savings could potentially grow. Perhaps worse, our difficulty with compounding leads us to also underestimate the cost of waiting, making that option appear much too attractive and fostering procrastination.
What Motivates You More?
Now that you’ve examined different perspectives of the debt vs. investing issue, what do you do with this knowledge? It’s not what we know that ultimately matters, it is what we choose to do. Consider taking a best-of-the-best approach:
With modest apologies to all of my math teachers, math just never felt quite that good. Use those good feelings of accomplishment to help motivate you to stay on track and hammer away at the next debt on your list until you kill that one too.
If you have two debts with similar balances, then focus on pouring additional dollars into the debt with the highest interest rate. Take advantage of both mathematics and psychology to help dig your way out of debt and land firmly on the path toward financial independence.