How do I figure out that balance of debt or retirement savings?
I was on the phone the other day helping a good friend figure out retirement and debt repayment, and I realized that I never shared my own personal determination of whether to clear debt or save for retirement.
I do actually have a rule and I developed it after I cleared my debt because I saw how many pressures started coming down as I got older.
I had cleared my $60,000 debt quite young, about 18 months after I graduated so I never experienced having to think about retirement seriously and take care of my family and..  and..  and.. You know how it is.
Rule of Thumb for Debt or Retirement
If you have any debt charging an interest rate of more than 5%, prioritize paying that down first with at least 75% of your income after your necessary fixed and variable expenses (rent, food, utilities, gas).
Reasoning
The stock market on average returns 5% (I know some people say 7% but I am conservative in this assumption).
For any debt that is less than 5%, you are probably better off investing your money in the stock market, and any debt more than 5% (especially in the 10% or higher range), you will get more bang for your buck (so to speak), clearing that debt (and KEEPING IT CLEARED) than you probably would investing it in the stock market.
You can think of it as saving the difference.
If your debt is at 7%, and the stock market is returning 5%, the difference is 2%. You are gaining 2% more with your dollar by clearing your debt over investing it.
Quirks to consider
If you are younger than 40 or have more than $100,000 in debt, then I would say pay off your debt as a higher priority than saving for retirement.
Once you hit 40, you really only have 25 years to go before you retire, so you need to get cracking on this retirement boat because it passes your harbour and you are 50 years old with nothing in the bank.
At those two points, perhaps instead of 75% of your income, than 50%.
What’s your rule?
10 Comments
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SarahN
Like you – no debt (other than mortgage, which is less than 5%). That being said, I contribute about 15% of my salary to retirement, and I’m comfortable with where it’s at, so I’m putting extra money onto the mortgage.
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sherry@savespendsplurge.com
You’ve got a good plan in place. I don’t like all my eggs in one basket either.
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Jessie's Money
I don’t have a hard and fast rule like this – but just generally have evaluated debt interest rate and savings interest rate, combined with any cash flow needs and how quickly debt could be paid off or not. That, and balancing what has been important to my husband over the years. Right now, we’re sitting debt free except for a 0% loan on our second car.
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Taylor Lee @ Yuppie Millennial
My mortgage debt is >100k but <4% interest. I'm paying it off quickly until I hit mortgage = 2x my annual gross income, at which point I'll probably do 50% mortgage / 50% investments. I do prioritize my tax-advantaged investments (i.e. 401k) before mortgage, however. That's a non-negotiable.
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Kathryn @ Making Your Money Matter
This is great advice to use age and interest rates as the guidelines!
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Hazel
My advice would be contribute enough to the 401k to get the maximum company match (if offered) then throw every other spare dollar at the debt. I got a later start on seriously saving for retirement but I max everything out now I’m debt free. Without the debt I’d have a much more limited financial education so I don’t feel bad about the late start. I am very grateful for my debt stupidity as it has me smarter and more focused in the long run.