We all want to reach a point where we don’t have to work for a living. We’d like to relax and enjoy life without any financial stress. Of course, that won’t happen if you don’t save for retirement. But how can you save if you’re in debt? There are a few things to consider when you’re trying to balance saving for retirement with paying off debt.
Empty wallet picture from Shutterstock
We’ve asked how you juggle saving and paying off debt before. It’s a complicated question that depends on a variety of factors. Here’s what you should consider.
Before anything: build an emergency fund
Before you think about investing your money vs. paying off debt, make sure you have an emergency fund in place.
It seems counterintuitive to build up a savings cushion while you’re in debt, but it’s a crucial step to avoid getting stuck in a debt trap. So build up a small amount of savings while making your minimum debt payments. Most experts recommend saving at least three months’ worth of living expenses, but even a few hundred bucks is better than nothing.
When I was getting out of debt, it would have taken me forever to save three months’ worth of expenses and I wanted to get out of debt fast. At first, I tried going without an emergency fund altogether. That didn’t go over so well. When the inevitable emergency popped up, I’d put it on a card and my debt progress was immediately undone. So I compromised and saved $1000 for an emergency. It wasn’t as much as experts recommend, but it was enough to pay for small setbacks without undoing my debt progress. But I also had an emergency plan, in case of a bigger emergency: move back in with my family (who preferred me to stay at home, anyway). So I had options for every scenario.
Over at Bankrate, personal finance author Paula Langguth suggests systematically saving and paying off debt by creating milestones. For example, once you reach $500 in your emergency fund, increase your minimum debt payment by a certain amount, then reduce your emergency fund savings. At $2000, increase your payments more, reduce your savings amount even more, and so on.
Take advantage of Government co-contributions to your super
So you’ve saved for an emergency, and you’re making the minimum payments on your debt. If you can afford to make additional super contributions, the government may add to it. For every dollar you contribute from your after-tax income, the Government will put in 50 cents, up to a maximum of $500. This is basically free money, though you need to earn less than $50,454 to qualify. In short, take advantage of Government co-contributions as much as you can.
Figure out which goal is more important
After building an emergency fund and arranging for Government co-contributions to your super, the balance of paying off debt and saving isn’t so black and white. Debt is almost always the biggest priority. But ask yourself the following questions to figure out how to prioritise it along with your retirement.
How close are you to retirement?
If you’re getting close to retirement age, saving is going to be more of a priority. How much to save will also depend on your income, your debt payments and how close you are to retirement.
Personal finance writer Ramit Sethi says there are three ways to think about how to prioritise:
- The mathematical answer is to put your money where it will have the biggest impact. If your debt interest rate is lower than what interest rate you can expect from investing, pay the minimum on the debt each month and invest the rate.
- The emotional answer is that for many people, they hate having debt of any kind, so even if they’re paying off low-interest debt, it still makes sense for them.
- The hybrid approach is to split the difference: Pay off some of the debt and invest some. A nice compromise.
Most people automatically lean toward the mathematical answer, which makes the most sense on paper. But personal finance has a lot to do with mindset, so Sethi suggests the hybrid approach. It might especially be the best compromise if you’re nearing retirement age.
As a rule of thumb, you’re supposed to save 10 per cent of your income for retirement, but that’s not always possible. If you’re playing catch-up, you might need to contribute as much as you can. Use a retirement calculator to help figure out where you should be, and how much you need to save to get there.
You still want to head into retirement as debt-free as possible, though. So whichever approach you choose, getting rid of your high-interest debt should still be a priority.
What kind of debt do you have?
Add up all of your debt and take a look at your interest rates. Forbes contributor Laura Shin suggests:
Write these down in a spreadsheet from highest interest rate to lowest interest rate. Include everything from credit cards to car loans to your mortgage to student loans. This list will be helpful when trying to prioritise your debt payments against the potential growth of your retirement contributions.
If your interest rates are incredibly low (for example, let’s say you have a 0% car loan), it’s probably OK to postpone it while you save. Make your scheduled monthly debt payments, but then use your extra income for savings.
And then there’s your mortgage. It’s tempting to pay off your mortgage early, but most experts recommend focusing on saving for retirement first. As nice as it is to pay off your home, you want to take advantage of time when it comes to investing — you’ll come out ahead in the long run. Financial guru Dave Ramsey suggests investing 15 per cent of your income for retirement before you work towards boosting your mortgage payments.
But if you’ve got high-interest, revolving debt, like a credit card, it should be your first priority.
Financial planner Sophia Bera recommends tackling any debt with an interest rate of 6 per cent or higher. This advice is probably based on the general assumption of a 7 per cent average market return — if you have debt under 6 per cent, you’d likely come out ahead by prioritising investing. So, if you’re dealing with a debt below that, you might consider focusing on retirement. Of course, if you’re dealing with multiple debts, you want to add up all of the interest you’re paying on your total debt each year and compare it against how much you could earn saving for retirement.
Do the maths, and make sure you’re not paying more in interest than you could earning a return.
Budget for both goals
We’ll assume you have a basic budget in place to account for your living expenses and discretionary spending. After that, you’ll want to decide how much of your income to throw at debt, then how much you can afford to throw at retirement. Shin offers a guideline:
- Calculate how much money you have to throw at your financial goals, after drafting your basic budget.
- Add up the minimum payments on all of your debts.
- Subtract #2 from #1.
- Decide how much to allocate to each goal. If you have high-interest debt, you’ll probably want to allocate 100 per cent for now. For all other debt, adjust your percentage based on the above factors.
Again, you might consider setting a milestone for saving, then increasing your debt payment as you reach that savings goal. Or, vise versa: after paying off a certain amount of debt, you may decide to increase your retirement contribution.
Both getting out of debt and saving for retirement are important financial milestones. Tackling them both simultaneously can be a difficult balancing act. Taking stock of your situation and drafting a plan will help you come to a compromise and ensure you make the smartest financial decision for both goals.