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?
This article is about Ask the Readers, Choices, Debt, Retirement
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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.
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@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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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?
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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?
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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.
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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
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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!
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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)
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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!
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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.
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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.
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