Pay Off Debt or Save for Retirement?

Paying off debt. Saving for retirement. They’re both important to your financial health, but is one more important than the other? Can you manage to do both at the same time and call it a wise decision?

Ultimately, the answer depends on your current situation, including the types of debt you have and at what interest rates, and what retirement matching plan is offered by your employer. As your situation changes throughout life, your strategy to both pay off debt and save may change, and that’s okay.

Formulate a plan with manageable steps and automate your savings as much as you can. Here are eight steps you can follow to pay off debt and save for financial independence.

1. Figure out what you have and what you owe.

Essentially, this is a snapshot of your net worth. By laying out what your income is and what your debt obligations are, you can more clearly see your current balance between savings (for retirement and an emergency fund) and debt. Knowing where you’re starting from will not only show you which direction to take but will also show you when progress is made.

2. Find and list the interest rates on all of your debt.

Create a simple spreadsheet where you list out your total remaining debt balances, their interest rates, and the monthly minimum payments. Organize the debts from highest interest rate to lowest. Include credit cards, hospital debt, student loans, personal loans, payday loans, car loans, mortgage, etc. You will use this to prioritize debt payments against the potential growth of retirement contributions.

3. Create a budget.

The goal of your budget should be to pay all of your fixed expenses (rent, loan/debt minimums, insurance, etc.) and needs (food, utility bills, gas in car, clothing on your back, etc.) and then divert as much money as possible toward paying off debt, building an emergency savings fund, and saving for retirement. If you can set aside at least 20% of your net income for these goals (excluding what you put into your 401(k) pre-tax), then you’ll make progress at a steady pace.

4. See if you can refinance your loans.

If interest rates on car loans and mortgages are currently lower than when you took out the loans, it may be a smart move to refinance and take advantage of the lower rates. When refinancing your mortgage, consider looking at a shorter-term mortgage. See if your budget will comfortably allow the bump in monthly payments to shorten the loan and ultimately pay less in interest.

5. Reevaluate your credit card usage.

Start using your credit card like a debit card: only spend the money you have in the credit union. Cancel automatic charges and turn them into auto-debits from your checking account (if the expense still fits in your new budget). Call your credit card companies and ask for a lower interest rate or to wave the yearly fee. If you can’t lower the interest rate, see if you can transfer the balance to a card with a 0% interest offer. The goal is to not continue racking up credit card debt while you’re working to pay off the balance.

6. Create an emergency savings fund.

At minimum, you need one month’s worth net income saved for emergencies before aggressively paying down debt. While building your emergency fund, continue to pay the minimums on your loans and debt, but put all extra money into savings. Once you’ve saved your goal amount, apply those extra dollars toward paying down debt. An emergency fund prevents you from falling back on credit cards (and amassing more debt) when an unexpected expense comes up—like a car repair, vet bill, or home repair.

7. If you can afford it, take advantage of your employer’s 401(k) or 403(b) match. If you can’t, then cut expenses or earn more money so you can.

Not taking advantage of an employer retirement 401(k) or 403(b) match is like throwing away free money. While paying off the minimum monthly payments on your debt, do whatever it takes to take full advantage of the offered retirement match. If they’ll match up to 6%, scrounge every penny to meet that full 6%. It’s an immediate return on your investment.

8. Now figure out how much you can pay toward your debt.

You have a budget that prioritizes saving and debt repayment. You’re cutting expenses and perhaps creating new income. You have an emergency fund of at least one month’s net income. You’re making the minimum monthly loan payments. You’re meeting any retirement match offered by your employer.

Now’s the point where you aggressively pay down your debt. Where before every extra dollar not paying for food or the mortgage went toward your emergency fund and then your company’s retirement match program, now any and all extra money goes toward paying off debt, starting with the loan with the highest interest rate.

Depending on your time horizon for retirement and the interest rate on your debts, you may be advised to shift the balance of those extra dollars in favor of saving for retirement. Or, if you have any debts with higher interest rates, some financial advisors suggest paying off those debts first before going back to minimum payments on lower-interest-rate loans and more aggressive retirement savings.