According to a recent survey by the Transamerica Center for Retirement Studies (2017), paying off debt and saving for retirement are formidable competing priorities for many Americans. In the study, 66 percent of all workers cited paying off debt as a financial priority, and saving for retirement was listed as a priority by 57 percent of all workers. Not surprisingly, younger generations (72% of Gen-Xers and 67% of millennials) highlighted paying off debt as the larger priority, while 72% of boomers considered saving for retirement to be more important. So, which should come first?
Which Should Come First: Pay off Debt or Save for Retirement?
This is a difficult question for many people, especially those that might be getting their first job after graduating. They have a student loan, maybe a couple of credit cards. The retirement account with their employer looks good, but should they start contributing, or pay off the debt first?
First, realize this isn’t an all-or-nothing proposition. There are advantages to paying off debt first, as well as advantages to saving for retirement first. But you can do both at the same time, it’s just a matter of degree.
Think of it like a cut or a dissolve in a film. If you’re watching a scene and it goes immediately to the next situation, that’s a cut. If it gradually transitions from one scene to another, that’s a dissolve.
You can accomplish two financial objectives, paying down debt and building your retirement account simultaneously – you don’t have cut from one to the other. Instead, you can start with both and then transition or “dissolve” into solely focusing on saving for retirement. There are a number of reasons to try to put some money away for retirement and pay off debts at the same time. But for now, let’s look at some of the advantages and disadvantages of paying off debt first or saving for retirement first.
The Advantages of Saving for Retirement First
Starting Can Be the Hardest Part: At least you’ve gotten started. If you wait until everything else is in order to start saving for retirement, you might be retired before that happens! Once you have started saving for retirement and you’re doing it in a systematic way, you might find it to be pretty easy – especially if it’s an automated contribution into an employer-sponsored 401(k). Pay yourself first!
Tax Benefits: There can be tax advantages with some types of retirement account contributions, and also tax advantages to holding certain types of debt. For example, student loan interest can often be deductible, as can mortgage interest.
Company Matching: You might also find that if you don’t start saving for retirement through an employer-sponsored 401(k), you might be missing out on a company match. Your employer might match, let’s say, the first 3 or 5% of your contributions. In most situations, you’re probably going to want to make sure that you contribute at least that amount, otherwise, you’re leaving “free money” from your employer on the table.
The Magic of Compounding: Over long periods of time, your returns might be larger by contributing to your retirement account than the amount that you would save in interest by paying down debt. Of course, this isn’t always the case. We don’t know what the market is going to do from day to day or year to year, but the opportunity to compound over long periods of time improves the chances of getting better returns from saving sooner.
Income-Based Student Loan Payment Plans: In general, some contributions to your deferred retirement accounts can affect the discretionary income that’s taken into consideration when determining what your student loan payments will be in future months. That said, there are multiple different kinds of income-based payment plans, so talk to your servicer to find out exactly which type of payment plan you’re on and to ask any specific questions about your unique situation.
The Advantages of Paying Down Debt First
The Tony Soprano-Style Loan: Payday loans, car title loans, credit card cash advances and pawnshop loans are examples of the worst of the worst debts. They often tack on various charges and fees, and they can charge exorbitant interest rates. If you have very high-interest rates or other negative terms associated with an account, it’s probably a good idea to pay off those types of debts sooner rather than later. Bad debts can spiral out of control and do more damage than saving for retirement can do good.
The Psychology of Debt: The simple concept of peace of mind makes us more likely to want to pay down debt first, and in the financial planning process, we don’t want to ignore that psychology completely. We’re planning for people, not necessarily for businesses or abstract concepts. Let’s look at some psychological reasons paying debt gives us more peace of mind than saving for retirement.
We Hope for the Positive with Less Intensity than We Fear the Negative: This is very easy to intuitively understand: think of what your income or earnings are for the year. Which gives you a stronger emotional reaction, a doubling of that amount, or watching it get cut it in half? The anxiety that most people would feel with a reduction likely exceeds the positive reaction that they would have for a corresponding increase. You may more likely to have an immediate positive reaction to halving your debt than to doubling your 401(k), especially if you’ve just started saving.
Frequency Vs. Magnitude of Financial Transactions: As humans, we tend to focus on the number of transactions rather than their magnitude. The book Predictably Irrational: The Hidden Forces That Shape Our Decisions by Dan Ariely does an excellent job explaining this concept. (As an aside, this is a very enjoyable book, written for anybody, no economics background required.) If you’ve ever gotten paid weekly, rather than monthly or biweekly, it might have felt like you had more money, even though you simply received smaller amounts more often. Or if you spend $15 for lunch, versus $10 for lunch and $4 to park. We know the whole lunch experience cost a buck less overall, but we perceive the value differently.
We see the same thing with stocks that pay dividends. Even though a non-dividend paying stock might perform better than a dividend-paying stock, receiving dividends might make you “feel” like you’re getting better returns. Again, we respond more favorably to the frequency than the magnitude. Someone with a million-dollar house and a $100,000 mortgage might be perceived as less well-off than someone that with a $500,000 house that they own free and clear, even though the first person has the higher net worth.
When you reduce a debt, you have one less negative thing – that’s very easy to comprehend. But it might not come at the right price, given the magnitude of the effect on your other accounts. You want to take everything into account together.
Debt Fatigue: On the other side, our minds can sabotage our own good intentions in paying off those debts. You might be slowly but surely making progress whittling down that amount owed, but after a while, you just don’t really see much correlation between your efforts and the fruits of your labor. It just seems insurmountable. “I’m $30,000 in debt, but I want to go on vacation. $31,000 versus $30,000, what’s the difference? I’m in debt either way.” That’s debt fatigue. But how many people would take that $1,000 out of their retirement account to fund their vacation? Probably not as many.
Every situation is unique. If you are asking yourself, “Should I pay off debt or save for retirement first?”, don’t hesitate to get in touch with us at Pure Financial Advisors.