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Ask the Readers: Pay Down Debt or Save for Retirement? Print
Friday, 9th May 2008 (by J.D.)This article is about Ask the Readers, Choices, Debt, Retirement
Personal finance is filled with tough decisions. Prepay the mortgage or invest the money? Pay down high interest debt first or use a debt snowball to tackle the small balances? Roth IRA or traditional IRA?
Sara wrote recently with another dilemma I think many of us have faced: is it better to pay down debt or to begin investing for the future?
I’m 28. I work at a job with no retirement benefits and I want to open a Roth IRA.
My husband and I have about $9,000 in credit debt on a credit card which, unfortunately, has a high interest rate. (I plan on transferring the balance soon, but am investigating cards carefully.) We also have a small loan that we are paying off quickly.
Your recent posts on the benefits of compound interest for retirement are making me question my current plan of “pay off all debts first, then invest”. I don’t want to lose out on the benefit of time any longer. What should I do? If I have $600 a month to throw at something, is it better to focus it all on the debt, or start on my Roth?
In this case, it might be helpful to reframe the question. Would you take out a loan at 12% or 15% or 18% interest in order to make an investment with an uncertain return (but which would most likely yield about 8%)? That’s basically the situation here. From a purely mathematical perspective, it doesn’t make much sense.
But there’s more than math involved in this decision. Building retirement savings can be a powerful motivator. Just getting in the habit of setting money aside is a valuable skill itself. Although there’s a cost involved, I wouldn’t say that it’s wrong to save for retirement while also repaying debt.
As always, do what works for you. If the debt bothers you, or if you think you might struggle to pay it off otherwise, then focus on the debt. But if you’re worried about the lack of retirement savings, then focus on that.
I did a little of both. While I was paying off my debt, I began to set aside a little cash every month to fund my retirement. It wasn’t a lot at first — just $100 — but as my expenses dropped and my income grew, I was able to contribute more. This allowed me to get into the habit of saving while also making progress on debt reduction. I know that I wasn’t making the most of either situation, but I didn’t care — it felt right for me. (And to be honest, I’d probably take the same approach again.)
What about you? What would you do in a situation like this? (Or what have you done in a situation like this?) Would you sacrifice a few hundred dollars in order to develop the saving habit? Or would you buckle down and get that debt paid off first?
May 9th, 2008 at 5:12 am
I would agree with JD on this one. It’s good to get into the savings habit, and it will be a great motivator to see an investment account go UP while your debt is going down. Of the $600 you have to utilize, I would say put $100 into the Roth IRA and the other $500 throw at the debt. It will only extend your payments 3 months, but in the meanwhile you will have developed a good (hopefully lifelong) habit of saving. Good luck to you!
May 9th, 2008 at 5:21 am
We had a lot of debt and considered dropping our 10% savings to our 401K to pay down the debt but when we called to do that our HR person said that it wouldn’t be wise because our income would not increase much. It was just enough of a deduction before taxes that plunked us in a lower tax bracket, couple that with what we were receiving matching funds on 6% of the 10% that it was worth saving. We plugged away with the debt and finally got rid of it and our retirement grew to a decent amount.
May 9th, 2008 at 5:22 am
I have done the same as you JD, both paying off debt and saving for retirement. I am older (40) than Sara and do not have the luxury of time on my side anymore so I felt it is necessary to contribute to a Roth IRA as well as squashing the debt.
It has worked out well, my debt is gone, with the help of a windfall I have a comfortable emergency fund that is still being added to, and contribute to 401K and Roth IRA.
The biggest comfort for me is the emergency fund, it stops the worry and the cycle of using a credit card to cover the inevitable emergencies.
May 9th, 2008 at 5:24 am
I would do both. Since Roth IRAs are harder to tap into, you don’t need to be successful in getting out of debt to have some retirement savings.
May 9th, 2008 at 5:27 am
I’ve always been more of a math person vs a gratification person. I’ll always work from the lowest interest rate to the highest. Right now, I do actually put 5% into retirement but that’s because it’s matched by my employer up to 5% so it’s worth the 12% interest loan for what would be more than 100% yearly interest (I think). If no matching was given, I wouldn’t give a second thought of cutting the retirement savings. It wouldn’t be doing as much good as paying the credit card debt off would be.
May 9th, 2008 at 5:30 am
If Sara can find a card with a good balance transfer offer, then I would contribute even more than $100 towards the IRA. Otherwise you’ll only contribute $1200 this year, and you’ll never be able to make up the other $3800.
Also, for this year at least, consider a Traditional IRA so that you get some immediate tax savings, which can be used to pay down your debt when you get next April’s tax refund.
Assuming a 12 month 0% balance transfer and contributing $300 to each, we get:
1. $3600 applied to debt, $5400 remaining
2. $3600 tax deduction from IRA contributions, assuming 25% tax bracket, reduces taxes by $900
3. $900 refund applied to debt, $4500 remaining
Then do another balance transfer or just focus all $600 on it for 8 months.
May 9th, 2008 at 5:32 am
Don’t forget that any money you put into a Roth IRA has the potential to grow tax-free for decades, which is a substantial opportunity to make compounding work for you. You can only put a certain amount into your Roth each year, so it’s a limited opportunity with major long-term implications.
I wouldn’t neglect your credit card payments, but a dollar put into your Roth today is worth more than a dollar put into your Roth a few years from now.
May 9th, 2008 at 5:36 am
I’ve never had any significant debt (except my mortgage). Obviously, high interest debt has to be paid down.
Most people get a psychological benefit from an emergency fund when they have debt. I’m not really one of those people so much, and probably would just hammer on the credit card debt, paying as much as I could and as early in the month as I could afford it.
For the most part, I’ve chosen not to prepay my mortgage, but rather to focus on my IRA and 403(b) contributions (I do not get a match).
However, this year I decided to start some small prepayment on my mortgage in order to get it paid off at age 59, 5 years after my earliest retirement date (i.e. I’m on track to be able to collect my pension at age 54). I might retire early, depending on the state of health care in 20 years (i.e. I might have to keep working if some version of Hillarycare is not in place).
May 9th, 2008 at 5:41 am
I personally like the 12-18 month rule. If you can focus solely on paying off debt and be completely debt free in that time then halt retirement contributions and kill off the debt. If it takes any longer, or you have a huge debt load, I like the idea of doing some of both so you don’t miss the potential gains from compounding.
May 9th, 2008 at 5:43 am
I am doing something modified…I’m paying off all of my high interest debts *first* and then when I get it down to my college loans (which I have a low rate on), *then* I’ll start to put some more toward my retirement. At long last, though, (and I’ve been an idiot for missing this), I do now make sure I put enough into my company’s 401K to qualify for my employer’s match. I followed JD’s ‘math theory’ as above…it just didn’t make sense to be putting money away at 6-8% when I still had some debts in the 13-21% range.
I ran different scenarios over at the Debt Payoff Calculator at Bankrate to double-check my ‘gut instinct’ on this: http://www.bankrate.com/brm/calculators/creditcards/debt_payoff_calculator.asp
I experimented with putting in different ‘accelerated payment’ amounts (the additional amount I wish to pay each month, to more quickly payoff my debts). Say, if I said I had $500 total a month to throw at my situation, I might run different calculations for $300 to debt/$200 savings, $400/$100 savings, or the whole $500 toward debt. This was beneficial to me because then I could see what could be paid and by when…and timing and a ‘finish date’ is a big goal and motivator for me. Even after I get my high interest date paid (this August), I still only plan on contributing about $200/month to retirement and that still allows an accelerated payoff on college loans. I’m tired of having this ‘weight’ looming over me…it’s *that* important that I get out from under it ASAP.
I’ve got 10 years on Sara, am not married, and have been hit with substantial medical bills in recent years (now paid). To me, it made sense to get the debt finally paid (or at least until I just get down to my college loans only), before throwing anything into retirement savings. I know that’s not a plan for everyone my age, but I think getting the high interest debts out of the way makes the process easier for me.
To each their own, though, to each their own. And best of luck to Sara and family…everybody has to do it their own way to fit their own specific goals, their own specific needs.
May 9th, 2008 at 5:44 am
I was in very nearly the same position as Sara (same age, slightly more CC debt but not a whole lot, though my employer offered 401(k)), and I did both. I budgeted the living daylights out of everything, and then used an excel spreadsheet to work out various scenarios, and I wound up investing a small amount in my retirement and a savings account, so as to have *something*, while sending most of it to credit cards. I didn’t see a major tax advantage to the retirement savings (i.e., didn’t get dropped into a lower tax bracket) though I did take that into consideration while calculating strategies — it just didn’t work out for me, but maybe it could work out for Sara. It was mostly just for my personal comfort, which sometimes trumps math (though I do really like having the math there so I can at least start from a level, objective playing field before I start adding in factors like “but that makes me anxious”) — I was getting to the point where I could feel my retirement-savings-age slipping away from me, which made me just about as antsy as the credit card debt.
In the end, my breakdown was something like $200 to retirement, $100 to savings each month, with the rest of my available cash to debt. The extra $300/month would have cut maybe two or three months off of the debt repayment time, which wasn’t worth it to me since it was so incredibly nice to see the ever-increasing balances on my savings/retirement. I think having both the shrinking credit card balance and the growing savings really combined to make me feel like everything was under control at last. So I recommend that route, as opposed to strict attention to just the debt. The math works out unfavorably, but every time you realize you actually have savings now *totally* makes up for the sting of loss.
May 9th, 2008 at 5:46 am
I am trunk on the Dave Ramsey coolaide. I would say get on the baby steps. Get your $1000 emergency fund then on to Step 2. Pay off the debt via the snowball. Then you can start saving.
May 9th, 2008 at 5:47 am
Did Sara actually say she was paying 18% interest or was that your guess?
I have never heard of a card with 18% interest, or at least not since the late 1980s. I would consider 13% to be high.
May 9th, 2008 at 5:52 am
As usual, I agree with J.D. and think that as long as you have a plan to pay off the debt in a few years or less, you should find a way to contribute to both the debt and retirement. But if adding to the retirement account means it will take you 15 years to pay off that debt, then you should certainly focus on the debt.
The power of compounding is just too much to pass up at a young age to completely ignore it. For example, let’s say you take $1,000 and apply it towards retirement instead of the debt. Sure, at 18%, you’re “losing” $180. But, take that same $1,000 and invest it, averaging 8% returns over the next 30 years, and it turns into about $10,000.
Being relatively young, you have the luxury of saving less, and let time and compounding do the work for you. But if you wait a few years, you’ll just have to contribute more to make up the difference that even a few thousand dollars makes over the course of 30 or more years.
So, strike a balance so that you can still pay your debt off in a short amount of time while also getting into the habit of saving for retirement. Also, as someone mentioned, you might not want to abandon the traditional IRA idea either, since the tax savings could negate the interest you would have otherwise paid.
May 9th, 2008 at 5:58 am
Paying off debt is a guaranteed return. The ultra-risk averse should pay down debt, including their mortgage. High interest debt should rationally be a high priority because it can quickly become overwhelming. For mortgage and car payment debt most people should probably find a good mix of investing and paying it down. After-all most personal finance is behavioral so you need to establish good habits.
May 9th, 2008 at 6:05 am
Do you have “emergency fund” money? Money that you don’t anticipate spending, but its on-hand, liquid, and safe and sound if you need it? If so, I would put *that* into a Roth. Since you can withdraw contributions (but not earnings) penalty-free, you still have it. But if you don’t, you’ve taken advantage of the Roth tax benefits. (Of course, given the situation I would keep that Roth money in low-risk investments until you have developed an external emergency fund.)
May 9th, 2008 at 6:09 am
My husband and I paid off our debt ($55,500) while also maxing out our 401ks. We could have made quicker progress on our debt snowball if we had suspended our 401k contributions.
For us it was important to continue retirement savings because of our age (35-36 at the time) and because we both got a late start on retirement savings because of extended education.
However, we made the choice to continue 401k contributions only after doing a ton of number crunching and figuring out we could do both (pay off debt and save).
If I were the OP, I would also be working really hard on tracking expenses, budgeting and increasing the amount she has to use to pay off debt/save.
I agree with the Dave Ramsey philosophy that focusing all your energy on one goal really works. If you get really focused on killing that $9000 debt you probably could figure out a way to get rid of it way quicker but you would have to adjust your lifestyle.
May 9th, 2008 at 6:16 am
I agree with Frugal Dad - if you can wipe out the debt in less than 18 months (which it appears she can), attack the debt and get it out of the way. Then start plowing the $600/month into the Roth.
May 9th, 2008 at 6:20 am
I’d say it depends on the exact interest rate on the $9000. How much higher is the APR on the debt than the APY on what you would invest? If APR >> APY I say throw everything you have at debt. If APR ~ APY then save and pay down debt. It makes no sense to lose more money in debt interest payments than you are getting back in savings interest.
I am 23, have a substantial stable income for the first time, and was up to $8000 in credit debt. I threw everything at my credit cards for the last 8 months, and I’m now down ~$3500 in credit debt, and after some strategic balance transfers I am paying 4% interest on it. Which means opening a money market account at 3.56% APY for an emergency savings fund finally makes sense, whereas it didn’t when I was paying 12% on $8000.
May 9th, 2008 at 6:23 am
Caitlin wrote: Did Sara actually say she was paying 18% interest or was that your guess?
Those numbers are purely a fabrication of my very creative mind. I was using the numbers that I always used as rules of thumb when I was struggling with debt. I’ll add an “(or 13%)” to the entry…
May 9th, 2008 at 6:25 am
Caitlin - really? 29.99% APR is not uncommon, unfortunately. You must have very good credit management habits to have the luxury to consider 13% high.
I was thrilled to get a card *down to* 12.99% after paying off my debt!
May 9th, 2008 at 6:48 am
This really depends on the type of person Sara is. Are she and her husband REALLY going to never run a balance on those cards? Have they stopped using them?
If they are fully committed to not using them, I would put that extra 600 a month on the card. And not use the card! But if they aren’t intense about it, I would split it, maybe 200 to the IRA and 400 to the card.
May 9th, 2008 at 6:54 am
I was in a similiar position as Sara a few years ago. I put away a small amount ($100) a month towards the Roth, socked the rest towards debt. Once the debt was gone, I split the Roth and emergency fund monthly savings.
May 9th, 2008 at 6:58 am
Don’t forget that the current IRA limit is $5000/year. So even if she wanted to, she couldn’t put $600/month into an IRA, at the most she could put in $416 on average per month. Granted, considering that it is already May, it would be possible to do that for this year.
May 9th, 2008 at 7:00 am
I started my first entry level job in September with about 3k in credit card debt and a LOT more in student loans. I had been reading finance books and blogs all summer after graduating, so I knew that I wanted to put money into my 401k AND pay down my debts at the same time.
For me, it was more important to do both. I know a lot of people have trouble focusing, which is why they have the debt snowball. It also doesn’t make sense for them to make an 8 or 9% return on their retirement accounts when they’re paying 20% interest on consumer debt. Still, I wanted to see my savings account grow every month.
I know Sara is talking about investing in a Roth IRA, but it also helped me to know that I was making a 50% match on my 401k. A guaranteed 50% to me really outweighed throwing that extra after-tax money at my credit cards.
May 9th, 2008 at 7:10 am
May 9th, 2008 at 7:18 am
JD-Good post. It shows that personal finance is not black and white.
I don’t see enough data to make a call. Sara shows $9k in credit card debt. What else is owed? What is the interest rate? What is their monthly income? How stable is their employment? That being said…here I go!
As a general rule of thumb, I recommend focusing all your energy into debt repayment for several reasons:
-Invest in the sure things first. I don’t know too many people who can make a higher return than credit card companies. Even if you can get a low rate on your cards, it is most likely 13%. A new investor-especially in this market-won’t beat that. A 29% return (to use Sabrina’s numbers) beats an 8% return (or even a loss) any day!
-They will be spending enough time learning how to cut expenses and say no to impulse buying. They don’t need to distract themselves by learning to invest as well.
-Most people can’t walk and chew gum at the same time. Telling them to focus on more than one thing at a time will lead to neither getting done. Especially with new habits.
-Paying down debt and getting control of your life is a powerful feeling. You need this small victory to move on to bigger financial accomplishments.
As for the emergency fund I don’t care either way. If you know you can trust yourself, keep one credit card for this. If you can’t put away $1000 first THEN pay down debt.
May 9th, 2008 at 7:19 am
Since there is no retirement savings plan at your company, I can’t give you my first recommendation, which would be to always contribute to retirement savings if there is a dollar match (especially if the match is a 1:1; 100% returns are pretty hard to pass up
).
Since that’s not an option for you, if you can pay off your total debt in 18 months or less, I would go psycho on the debt and do everything you can to clear it out. Sell stuff, take a second job if it makes sense, do something that will help get you focused and into the zone to pay of your debts, using the Debt Snowball or another method that allows you to get “medievel” on it. Once you have done that, then get serious about plugging into the ROTH.
Alternately, if it will take more than 18 months, or if you want to allow yourself a bit of a planned staging, determine a minimum amount that you will put into the ROTH, even if it’s as little as $50.00 a month. Put everything else towards slaying the debt. Each time you knock a debt payment out of your life, roll that payment into your debt snowball, plus roll a little more into the ROTH. Each time you ratchet up the snowball, the level of ROTH IRA contribution will increase, until you either clear out the debt or max out the ROTH IRA. Once the debt is out of the way, plow as much as you can into the ROTH and other vehicles to reach your “magic number” (I like Dave Ramsey’s 15%, but if you want to do more, by all means, do more
).
May 9th, 2008 at 7:25 am
I was in a somewhat similar position to Sara (28 this month, job has no retirement benefits, had nothing saved up until the start of this year). I would recommend opening the IRA and contributing a minimum while putting most of her extra $ toward the CC debt. Psychologically building up savings/investments in my future was huge, even though it started small. Helps get one into the right mindset and then once you tackle that CC debt you can begin fully funding your IRA.
May 9th, 2008 at 7:56 am
Personally, I’m working on both (and doing both slowly, because I’m a single mom and lower enlisted in the military, I don’t have much other option), but if I had to pick, I’d pay down debt first. Debt causes a lot of stress in life, and stress is detrimental to your health, which could raise health care costs.
Think about it.
May 9th, 2008 at 7:57 am
My wife and I recently erased our credit card debt while still maxing our roths and contributing to our 401/403 plans.
To do this, we transferred our debt to a 0% card so it wouldn’t keep compounding interest (compound interest can work against you, too). Then we set a plan to tackle it over the next 12 months and still put away towards our Roths.
My wife is 25, but I’m 32. We wanted to be sure to get the money in my Roth because I don’t have the time advantage she does.
Now we’re on a plan to tackle our car debt in 12 months. It might not be the plan for all, but it’s working for us.
The tough thing about it is knowing and following a several month (year) plan. It took us awhile to know and accept the debt wasn’t going away immediately. Good Luck!
May 9th, 2008 at 7:58 am
Personally, I don’t believe retirement savings count as an investment from a Ramsey/debt/retirement perspective.
Let me elaborate on my opinion: If you have $600 to ‘throw at something’ after the budget is done but are not already contributing to your retirement, then in my opinion, you don’t really have $600 to throw at something. You have $600 less whatever you *should have already been contributing* to your retirement.
In other words. Your retirement savings should be coming off the top line of your budget, not the bottom line. It should be your number one priority every single month. That is the only reliable way you are *ever* going to save enough. Optimally, it shouldn’t even be a factor in your budget at all, and you should consider your pay to be what you are making now minus a small retirement contribution, because having it as a line item in your budget implies that if you are having a tough month, you can forgo saving for retirement that one month.
Just remember: somebody will lend you money for anything else in life, but not for retirement.
May 9th, 2008 at 8:01 am
Also, I just wanted to add that it might seem like alot, but $9K in credit debt between two people isn’t really that much for a 28 year old.
Yeah, get rid of it as quickly as you can, and more importantly, don’t accrue any more, but you should be able to bounce that around to low rate or even 0% cards fairly easily. It will be gone before you know it.
May 9th, 2008 at 8:11 am
A little bit of both makes the mind feel at ease. Not to time the market, but you also need to consider where the market is right now… dropped a lot… not a bad time to be investing heavily.
But, paying off debt should be first in the long run. Maybe a 75%/25% split.
May 9th, 2008 at 8:25 am
Compounding isn’t really the issue - as you say, the debt interest compounds negatively faster than the investment gains can positively. However something that can’t be made up for later is the opportunity to contribute to a tax advantaged account for this year. So it might be worth it from that perspective. Depending on how long the “no retirement benefits at work” job goes on, Sara will definitely need to be maxing out her IRA for the forseeable future.
To those who suggest contributing to a Roth IRA: I would actually recommend contributing to a regular IRA now and using the tax savings to pay down more debt. Then once the debt is paid off, convert the traditional IRA to a Roth and pay the taxes at that point. A few years of pre-tax compounding may incur a few extra taxes, but not as much as the extra interest Sara would pay on the debts now.
May 9th, 2008 at 8:30 am
I’d buckle down hard and do both. But I think I’d put the retirement planning ahead of the debt payment - you can’t catch up on retirement later in life. You’ve got to stop using those cards first though. You guys sound like a big candidate for Dave Ramsey. You really should go to the library and get a copy of The Total Money Makeover. Good luck - its a rough road, but you can make it!
May 9th, 2008 at 8:37 am
I’m in a similar situation, although the only debt I carry is my mortgage ($114k) at 5.25%. I am in my mid-50s.
I have a $6k cash emergency fund in a savings account paying dismal interest. I also have accrued comp time worth approximately $6k that can be cashed out quickly in an emergency. The value of that grows at 4% annually with salary increases, more if we get a cost of living increase. In addition, I have a 401k worth approximately $38k that I put a mandatory (and limited) 3% of my salary into, and my employer contributes 7.5%; and two stock portfolios worth approximatly $106k ($6k is in a traditional IRA, the rest in annuities).
The options I am considering: Pay down my mortgage; or fund a pre-tax 457 plan here at work; or fund a Roth IRA through my stockbroker.
Any advice?
May 9th, 2008 at 8:39 am
I’m going to disagree with just about everyone here: max out the Roth first, then pay down debt.
The reason is this: once the opportunity to put money in the Roth goes away (once the tax year ends), it’s gone. Never again can you put that $4,000 into an account that grows taxfree. Never again.
Beyond that, if she has $600/month to spare, that’s $7,200 per year. Only $4,000 of that can go into her IRA per year, leaving a nice $3,200 per year to throw at debt. There will inevitably be windfalls along the way that can be thrown at the debt as well. Ignoring interest for a moment (both on the debt and on the IRA) that means she’ll have paid off the debt in three years and will have $12,000 in her IRA. If she pays off the debt first before funding her IRA, she’ll pay off the debt two years sooner, but will end up with only $8,000 in her IRA, despite the fact that she will have more money to invest than that - but she will have lost the opportunity to invest for her 2008 IRA. Gone, never to come again.
Looking at interest again, that $4,000 she couldn’t invest because she was so focused on debt will cause lost interest for decades. At 8%, she would have $8,000 in 9 years (37). In another 9 years (46), it would be $16,000. At 55, when she can start withdrawing earnings, she’ll have $32,000 - $28,000 more than her original investment. Spending an extra two years paying down a high interest loan has got to be worth an additional $28,000 in retirement.
May 9th, 2008 at 8:43 am
The thing to remember is that the government caps how much you can put into an IRA/Roth IRA per year, so just remember that you can’t just “catch up” after you pay off your debt. For 2008, the max contribution is $5000/$10000 for single/married people. For me, that means that while I am young (I am married and don’t have any children yet), I need to max out my IRA contribution every year. While it is important to pay off debt, the government cap puts a different spin on retirement savings strategy.
May 9th, 2008 at 8:45 am
Hi. I think I am closest to agreeing with #32 — even when one has a large debt and is focussing on reduction, you still have to spend money in other ways, on food and rent etc, so debt reduction isn’t the only line in your budget. If you think of “retirement savings” as just another line on the budget, it doesn’t mean that you’re choosing it over debt reduction, it just means that you see it as a legitimate item, like the food bill and utilities etc. It is, like the food bill and utilities, somewhat elastic — and maybe it’s only $25 or $50/month, but “retirement savings” can still be part of what you’re doing with your income each month.
I’m going to be “retiring” in July 1, but I’m planning to continue to, as I earn free-lance money or other income, to continue to put some money each month into savings…
May 9th, 2008 at 8:47 am
I agree with most of the comments. I’m not a big fan of Dave Ramsey because his snowball method vs. Highest interest rate method. Sara should definitely never stop saving for retirement. I am 26 years old am saving as much as I can for retirement while paying off some college loans. We have the advantage of time, Sara. Use it.
May 9th, 2008 at 8:51 am
I agree with J.D. - put a little into savings/retirement and a little to the debt.
Here’s what I would suggest doing - it’s a modified version of what we’re doing.
1. Find a 0% transfer and move the CC debt there.
2. Calculate the monthly payment required to pay off the debt before the 0% runs out.
3. Pay that amount and put the rest in savings/retirement. Always keep in mind that the sum of $600 is coming out and going to one of these two places - and nowhere else. Treat it like a fixed bill.
4. Add any extra income you’ve received during the month or any extra funds in the budget (”leftovers”) to the next debt payment (or go ahead and pay it).
5. Adjust the monthly payments remaining and the amount going to savings to equal $600 again - the future debt payments will go down and amount going to savings will go up.
6. Rinse and repeat every month. The monthly debt payments will dwindle down and the savings will get bigger each month. Eventually, all $600 will go toward the savings.
I said it was modified from what we’re actually doing.. We were recently married and my wonderful husband brought along $8000 in credit card debt (0% thank goodness!) and $22000 in an HELOC (variable), which he’d only been paying the interest on. I had no debt other than a little bit for the wedding (0%) that was paid off quickly. In addition, there was no emergency fund or any other savings. We combined incomes and bills, as there was no way he could have paid it off on his income alone. He saw bills as a chore and I was already meticulous in tracking my own bills and spending, so it was decided that I would take over the finances.
I have a set amount that goes to savings and another set amount that goes to debt each month. I use a similar method as described above to determine what goes where. Each month, the “leftovers” get split between debt and savings. The extra amount going to debt goes to the CC, and then the remaining payments are adjusted. Using a similar sliding scale, as each monthly CC payment gets lower, the HELOC payment gets bigger. By the end of the year (when the CC is paid off), all of it will be going to the HELOC, plus half of any “leftovers.”
I use MS Money to plan out future budgets and payments. The way I figure out how much is “leftover” is by looking ahead to the next month’s budget and pulling whatever is over a given buffer ($1000 in our case).
My husband and I have found this method to be successful. We were originally going to put all the extras into debt payment, but that made me really depressed. It was hard to handle everything going to a debt that I had nothing to do with. That may sound selfish, but it was a tough situation. I described it as paying for an invisible car that was misplaced. That’s when we decided a 50/50 savings/debt option was better. That way, we’re still tackling the debt plus putting money away for the e-fund, vacations, and house projects. True, we could pay it all off quicker, but we’d be miserable. It’s nice knowing that every dollar less that gets spent each month will help us in two ways - by reducing debt and being a little bit closer to our next vacation.
May 9th, 2008 at 9:02 am
We chose both, too. We’re saving a little bit (just 3%) in my retirement plan at work, and then paying down as much debt as we can this year. Once our smallish debts are done and all we have left are the mega student loans, we’ll focus heavily on retirement, the emergency fund, and saving for a house.
May 9th, 2008 at 9:04 am
By reading this post, I have another question now.
Does anyone know, we should invest for retirement or save for down payment for a house?
My husband and I are trying to save up to 20% down payment for the house right now. So we don’t need to pay for PMI.
But it is impossible to be done if we do both at the same time.
So I am wondering, if there is any good ideas out there.
May 9th, 2008 at 9:06 am
It’s great that you have $600 to direct to either your credit card debt or to retirement investing. You can wipe out your credit card debt quickly with that massive monthly amount. I would wipe out the credit card debt first because you are getting an immediate 12% (or whatever your interest rate is) return on your money. There are no guarantees with the stock market or even the bond market for that matter so I would hold off on the retirement investing. You also should have an emergency fund of several months of living expenses built up before investing.
May 9th, 2008 at 9:08 am
@Mrs ThePoint-I’m in the same boat. I want to start saving money for a down payment. I’m paying down debt and funded a emergency fund.
May 9th, 2008 at 9:23 am
I fund my Roth IRA despite my credit card and student loan debt. I don’t max it out- I couldn’t, anyway, I don’t make enough money to do so- but $50 gets deposited in there every month. I’m 28, most of the money in the Roth is from a roll-over of a 401k I had at a previous job (I was, mmm, 25, perhaps, when I started it). My feeling is that while it may not make sense mathematically, I certainly feel better about saving for my future because that’s going to happen regardless of what else I do to my financial situation. At some point, I will be retired and that will be what there is to live on. If I were to wait until my debt was completely paid off before even starting to save for retirement, it would take *years* for me to start saving, and I’m just not willing to forfeit those years. I plan to pay off my debt as fast as possible, but not at the expense of my future.
May 9th, 2008 at 9:35 am
According to the “Wealthy Barber”, IDEALLY we should take care of our present and our future. HOWEVER, he does state later in the book that as long as we are securing our future (retirement), having some debt or having less than savvy spending habits is “ok”. Personally, I think it depends on your situation. My husband and I have a lot of debt. But we also have just 14 years until retirement. We try to do a little of both, pay off debt and save for retirement. As we reduce our debt, the plan is to put more in retirement savings.
May 9th, 2008 at 10:06 am
The most important thing to do with that $600 is get used to it not being in your budget. Whether you do that by applying it to debt or to savings (retirement or otherwise), doesn’t matter to that core value.
That said, I’d probably split that “extra” $600 in *three* places:
1. The majority would go toward paying down debt; this is the mathematically-sound thing to do.
2. Of what’s left, the majority would go into a savings account used for an emergency fund. Never underestimate the power of the emergency fund, both practically and psychologically.
3. The remainder, then, would go into a Roth IRA; this last bit is entirely psychological, but as JD says — the habit has value.
Let me expand a bit on the emergency fund: I recently had a contractor go bankrupt after giving him over $3500 as a downpayment to repair damage to my house. I still need to repair that damage, but instead of needing to put it on credit, I only needed to pull $3500 from my emergency fund.
It felt great to be able to survive that much sudden loss, and still be able to get the work done on my house. Not only that, it felt great not to have to grow my credit footprint — I’m still making the same progress on eliminating debt.
It would have felt much worse to see months of debt-reduction work eliminated in a blink than it did to merely take the hit on my emergency fund.
May 9th, 2008 at 10:18 am
You do have until April 15th of 2009 to fund your IRA contribution for 2008.
May 9th, 2008 at 10:40 am
I’m doing the half & half too. I’m in a similar situation. I opened up a Roth IRA with T Rowe Price — w/ no minimum startup and just $50/month, the peace of mind knowing I have *something* puts me light years ahead! Meanwhile, I’m putting another $80/month toward an emergency fund and with $100-200 toward eliminating that CC debt, I’ll have a positive net worth by the end of summer.
So yeah. A little bit of each, getting in the eliminating debt & building wealth habit, and I feel like I’m maximizing my returns.
May 9th, 2008 at 10:41 am
@Mrs ThePoint
If you have to choose between the down payment on a house or retirement savings I would do the retirement savings. Why?
#1 You need a place to live, but you don’t NEED to own a house. In your particular market it may be a lot cheaper to rent than buy- almost anyone who bought in 2007 wishes they were still renting!
#2 You can have a wonderful life renting, you WON’T have a wonderful retirement unless you have money saved up. You could be forced into no win situations- do we eat or get medications this month?
Save for retirement first, then look for other ways save for the home. You can always scale back your house size too. A smaller house is a lot cheaper to buy, heat/cool, easier to clean etc.
May 9th, 2008 at 10:58 am
Really the math tells you to pay off the CC first. I’ve seen this as high as 29 percent. Even at 15 percent it’s a fantastic guaranteed return.
The problem is most people just run the card up again. The real trick is to make the transition mentally to always spend less than you make. If you can do this then certainly pay off the CC first, then save and never run up the card again.
If you can’t do this then pay towards the card and retirement in some ratio. If you’re mentally comfortable with always paying down about 5k of debt, so be it. But at least the retirement funds will be growing as well. And if you get matching on something take that, no questions.
May 9th, 2008 at 11:16 am
A few people, including Sara, mentioned Dave Ramsey’s baby steps, but no one really talked about *why* they work or even why someone should do them.
Here’s the secret, and Dave says this over and over on his show: Personal finance is 80% behaviour and only 20% knowledge (doing the math). He designed and arranged the baby steps the way he did because that maximises behaviour change.
So how does this work? Do the debt snowball first, before doing any retirement. The extra money you have from not doing your investing will only increase the rate of debt payoff. You will win like crazy because you can pay off debt when you behave and focus on it. Then you can focus on the emergency fund of 3-6 months expenses. Only then do you focus on the retirement savings.
You really can make up lost time in short order because when you don’t have any debts except the house, you can work on paying off the house with this same great focus. When you don’t have a house payment going to the bank, and instead you pay yourself that house payment in a good growth stock mutual fund, the couple years you paused retirement savings won’t even matter.
May 9th, 2008 at 11:49 am
You should do both, regardless of how small the first years worth of contributions to the Roth are. The habit of paying yourself now is worth it in the long run. Getting out of college, I had some serious debt (for me it was $4,000, but that is a lot for me) and I did both. My first years contributions to the Roth were only $1400, but since then I have maxed out each year. It showed me that no matter how tough it gets, always take care of yourself as well.
May 9th, 2008 at 11:50 am
My $.02:
Mathematically you are better off in both short term the long run if you pay off your higher % interest credit cards first. JD makes the point well: Don’t borrow with 12-20% credit card debt in hopes that you might make 9-10% on retirement investment.
If you can try and get a lower % rate on the credit card. A 12 month 0% deal would save you a lot. If the cc is at 12-20% then a 12 month 0% deal can save you $1080-1800 in interest.
Still I can see the emotional benefit of getting started on your retirement. If you want to do that then I’d say put $50 a month towards the retirement and the remaining $550 towards credit card. That way you are saving for retirement but the bulk of your surplus is still going to pay down the debt.
Jim
May 9th, 2008 at 11:50 am
I would pay down the debt first unless you can transfer the debt to a 0% credit card. I think it could be a psychological gain if you were able to pay off the debt. After paying off the debt, you would feel more confident and might even be able to start saving more.
May 9th, 2008 at 12:06 pm
Another point to consider is that 401-k/ IRA funds are protected by law should some lender decide to sue you - the lender can seize your bank savings account, but cannot touch your 401-k funds.
May 9th, 2008 at 12:42 pm
If your company matches what you invest in your retirement fund, you’re crazy not to invest enough to get the full match. I mean, at a 50% match - they invest 50 cents for every dollar you put away - that’s a 50% gain. Yikes! But after that, I’m all for paying down the debt and building an emergency fund before socking cash into an IRA.
May 9th, 2008 at 1:05 pm
After seeing Sarah’s additional comment, I think she’s on the right track. Since she has $2000 in an emergency fund, it makes perfect sense to reduce the amount she is putting into that fund and use it to start a Roth IRA.
She will be able to put $600 to debt, while putting a modest sum away for retirement, and additional funds for emergencies. If she continues to build up her emergency fund, then she can take amounts above the $1000 “buffer zone” and invest in CD’s to get better rates. In that case, I would recommend she take a look at JD’s post on CD ladders.
May 9th, 2008 at 1:27 pm
I think it’s a very personal decision that everyone has to come to with a great deal of thought.
Having said that, I know that for me the feeling of finishing the debt first was well worth it. Once I was done with the credit card I felt like I was more motivated to save that I would have been otherwise.
Best of luck Sara.
May 9th, 2008 at 1:31 pm
Several people have suggested transferring the debt to a 0% card. I did that myself, with my balance, to a 0% promotional APR on my cards — after having transferred all my debt off the several cards onto one, so I’d have just one bill to pay. However, my balance transfer was assessed a 3% transfer fee, which I don’t think anyone has pointed out yet. It’s important to take the balance transfer fees into consideration if you start going down that route. Just do the math before you transfer anything. Even with a small fee, it might still (probably will) work out in your favor mathematically, but it’s not a “freebie.” The bank still has to make money somehow.
(Also, at least on some of the balance transfer offers I’ve seen, if you are late with even one payment, you get hit with all the accrued interest you would have normally paid. So it’s important to be very conscientious with your due dates.)
Anyways, maybe the debt snowball method works for some, but I didn’t find it to be as great as some folks seem to, and I definitely don’t agree with the total abandonment of retirement savings. Financial security is not only about the math, it’s also about feeling good about where you’re at (or at least knowing you headed someplace good). And if taking a small slice out of debt repayment and directing it towards retirement makes you feel good, then I say do it, even at the cost of a short extension to your debt repayment timeframe. I would rather have had two extra “good” debt repayment months, when I felt I was in control and everything was well in hand and on schedule, than one fewer “bad” month because I felt so broke, anxious, and uncertain (and I had enough of those to know). Ultimately, debt repayment wasn’t about the money so much as it was about me.
I’ll be curious to see what the final decision ends up being. Maybe Sara could write a guest post as a follow-up after a little while of following her plan.
May 9th, 2008 at 1:43 pm
Since it’s a high interest loan, I’d do this:
Work hard to quickly save 3 or 4 months worth of living expenses.
THEN (or if you’ve already done that), put all your money toward the loans.
May 9th, 2008 at 2:53 pm
I’m doing both: saving for retirement AND paying off debt. I have a total debt of $20,000. I pay $1500 a month on these cards (more than the minimum).
At the urging of my father, I bought 2 mutual funds through ING Direct & some dividend-paying stocks through Sharebuilder.com. I invest $100 a month in these investments and I feel confident that I am at least STARTING to save for my retirement.
My hope is that as I get better at my job, I’ll get more raises which will allow me to pay off my debt faster and invest more for the future.
May 10th, 2008 at 8:07 am
There is a lot of really bad advice in this comment section. You don’t need to do “what is right for you” in this situation. You need to realize what is right for you. Consumer debt at 20-30% rates is going to drag you down a lot more than any “miracle of compound interest” Roth earnings are going to lift you up. You get a guaranteed return on your debt payments which is much more than you can say about IRA contributions. Unless you know how to time the market and you expect your investments to beat the market 4 times over there is absolutely no reason to do anything other than plow all of your money into paying off debt.
I know getting out of debt isn’t fun but as someone who himself has climbed out of about $10,000 of credit card debt I can promise you that you want that stuff in your rear view mirror. If you can show the discipline to pay off consumer debt you will be very wary of letting it build up again. Then you can start watching your savings grow (my IRA btw hasn’t had more than 5% return over the last few years. Compound interest isn’t so miraculous when the market is stagnant). Get out of debt.
May 10th, 2008 at 4:17 pm
Pay yourself first. For 2008, you can contribute $5000. That’s about $416 per month for the next 12 months, which should get you to the April 15, 2009 deadline for 2008 IRA contributions. You’ll still have $183 extra per month to throw at your debt. In the meantime, some minor lifestyle changes can probably get that $183 up to $200 or more. You won’t have to second guess yourself because 1)you’ll be doing what you truly want to do, which is to save for retirement 2)almost subconsciously, you’ll be figuring out ways to stretch your money to help pay down your debts more quickly 3)you’ll feel like you’re working for yourself instead of the CC companies and you’ll get an emotional boost from that as well.
May 10th, 2008 at 4:24 pm
As someone who was once in the same position, I too struggled with this decision. However, in the end it was clear to me that future savings are impacted by debt. As long as you have debt, you aren’t really saving anything. I was once in the cycle where I was desparate to get rid of the debt, so I threw every last dollar at it. That didn’t really work either. Every time I had an unexpected expense, with no money in savings, I had to hit the cards again. The only way I was able to make headway was to put MOST of my money towards the debt and about 10% in a savings account. If you have significant debt, you can’t afford a retirement account. That money is locked up and you’ll take big penalties on it. If you want to get ahead, pay your debt and put your savings into an emergency savings account with no withdrawal penalties. If you have debt, you will need that money. If you put that money into a retirement account, you are hurting your options for getting out of debt. You won’t have a retirement if you have debt. Got it?
May 10th, 2008 at 9:14 pm
At my new job, I can contribute 1 to 15% of my wage to an RRSP plan pre-tax deductions. Yes, I’m in Canada. They will match one third of the first 6% of my wages. Not 1:1, but better than nothing for sure.
I asked their financial company who sets this all up, what their fees are and they said 2.25%. Now I figured it’d be better to not contribute, at least for now, and invest in some Index Funds that charge only 0.69% fees.
I haven’t run any numbers, but is that a wise choice on my part?
May 11th, 2008 at 9:53 am
Pay down the debt — no question. I fully paid off my debt before starting retirement. It was such a great sense of freedom to be done with the debt that I was happy to start planning for the future.
July 30th, 2008 at 7:13 am
I agree with you JD. You need to do both. You need to build up your assets while you are paying off debt. When the debt is gone then you can really focus on asset building
September 10th, 2008 at 12:45 pm
I’m in favour of paying down debt first as you can see form this article: http://www.btgnow.net/2008/08/what-do-i-do-with-money-ive-saved-4-thing-to-consider/
…but I realize there are a variety of point on this topic. I’d say put almost everything towards debt repayment (after taking care of your fixed and variable expenses for the month), and with whatever money you have left over (ie you’re “spending” money, invest 50% of it. If you don’t have any money left over to spend, you don’t have anything left to invest, so get that debt down pronto!
October 24th, 2008 at 12:02 am
I am actually in a similar situation. I am credit card debt free, but I have about $65000 in private student loan debt (down about $20000 from a year and a half ago). The student loan debt is 9.5% interest. I’m thinking about opening a Roth IRA this year, but I’m getting conflicting advice as to whether I should pay off the loan first or not. Even with the “Snowball effect” that debt will still take several years to pay off. I’m 25, so I’m just not sure what the proper course of action is. There is no 401K matching program at my current job, so that incentive is not there. I don’t have a house or car payment right now, so rent and student loan are my main expenses (I also have a $2000 emergency fund)
December 28th, 2008 at 2:11 pm
Interesting that there no responses since the financial crisis! I will be the first then……in recent years we had taken a home equity loan (in addition to mortgage) and a car loan while continuing to fund our IRAs heavily (we are self-employed so can make larger contributions) and these were gaining in the last 5 years’ markets; when the market went down we lost alot of the gains. Now we are planning how to re-pay the debt, with big losses in our portfolio and who knows what kind of returns and risk to expect in the next year. The car loan is 7+% and the home equity is variable, very low now but if inflation kicks in it would go up. So what to pay first: IRAs, car loan or home equity loan? It seems obvious to pay off the car loan since it is the most expensive, then the home equity loan, then fund the IRAs. HOWEVER I am wondering about keeping the equity line and rather building up a larger cash reserve - like a year’s income - in this economy. It may not be that easy anymore in this economy and self-employed to get credit in case you need it, so maybe we should keep these credit lines.
ANOTHER think I am wondering is whether I should fund my IRA this year from my brokerage account, which is non-IRA and in cash now. I think the answer to this is yes.
Any views appreciated!
April 24th, 2009 at 9:05 pm
Your car is a secured loan. Your HEqu loan is variable rate. Pay off the HEqu loan first and then concentrate on the car loan. Might consider reading the used book How To Get Out of Debt, Stay Out of Debt and Live Prosperously by Jerrold Mundis. it is well worth it.
May 20th, 2009 at 8:04 am
In my opinion, pay off all your debt first and heres why. Its very challenging to save in this day and age through conventional methods. I look no further than my 401k statement for which I have 80% invested in guaranteed growth right now for obvious reasons. When banks barely give you 1.25% on a savings account, what is the incentive to save. Sure there are institutions paying more but look at the requirments and limitations placed on your money. My guaranteed growth account has a 1.65% expense ratio, do the math there. But go ahead, invest and get blitzed by funds that are front loaded, back loaded, charge all sorts of fees, and ridiculous expense ratios. Then you have the taxation. All your hard earned money trying to work for you while you assume all the risk in investing, and look at all the hands dipping in to take their entitlement. All for a meager 8%, remember, that is before taxes. Its no wonder people are so discouraged with saving. For those who have mortgages, remember jumping through all the hoops just to get the money in hand. Closing costs, many charges being duplicated and unneccessary, but the bank was happy to finance those costs for you. How about the discount points, origination fees, appraisals that mean nothing, and a credit scoring system that does not favor folks who have no debt at all. Not only that, you pay interest on the note too, the latter of which most people are willing to accept, but whom are oblivious to the real costs of closing. Especially when banks finance those charges. It is a value worth reckoning with when making this decision whether to invest right now or eliminate debt. My bet is on debt elimination. All the best of luck, -Sean D.