Should You Save for Retirement or Pay Off Debt?

When it comes to personal finance, there is a lot of contradictory advice flying around. Today, I’m going to explain why you should save for retirement while you pay off debt. Don’t wait until you’re debt free to start – especially if you’re aiming for financial independence!

Why You Need To Save for Retirement NOW

The idea that you should be debt free before saving for retirement probably comes from the inimitable Dave Ramsey. This is clearly listed as the fourth baby step. Despite this, I feel comfortable contradicting the Dave Ramsey thanks to two core principles:

1. The easiest, nearly foolproof way to have your retirement accounts make money is to invest in the stock market for the long-term. This is often referred to as a “buy and hold” strategy. Of note, the S&P 500 – which many index funds mirror – has never lost money over a 20 year period. That is decidedly not true for shorter time frames. Check out this cool interactive graph for reference, with S&P 500 returns going back to 1927!
2. The earlier you start investing, the harder your money works for you! Here’s an example taken from MoneyUnder30: if you put in $1,000/month into your 401k from ages 25-35, then stopped, you would have $1,444,969 in your account at age 65 (assuming a 7% return). If you put in that same amount from ages 45-55, with the same 7% return, you would only have $373,407 at age 65. Womp womp.

The takeaway? Start investing as soon as you conceivably can. If you work for an employer, start investing in their 401k plan and/or open a Roth. Yes, do this even while you’re paying off student loans, car loans, credit card loans, etc. Because while you’re working hard to pay off your loans, your investments will be working hard to earn you money – without any additional effort on your end!

What About Paying Off Debt?

Of course, don’t save for retirement and forget to pay off your debts. Here is the debt strategy I’ve followed, with some additions for high-interest debt:

1. Make the minimum payments on all your debts every month and put at least $1000 in an emergency savings fund.
2. Start putting money into your retirement accounts, ideally enough to get your employer’s matching contributions. Otherwise, pick an amount you can afford to contribute every month – don’t worry about how much it is.
3. Look into refinancing your high-interest debt (especially if it’s over 7%) to a lower interest rate.
4. Put all your additional money into starting either a debt snowball or a debt avalanche. It doesn’t really matter which one you pick, as long as you stick to it.
5. Once have paid off all debt with more than 7% interest, you can choose to divert more money into your retirement savings OR keep on plugging away at debt pay off. Do whichever feels right to you!
6. When you’re debt free – or only have your mortgage left – take all that cash flow you’ve been using to pay down debt and turn it towards fully funding your retirement and other savings accounts.

Note: after writing this, I found that the Simple Dollar has a similar recommendation. Check it out for more resources!

Other Things to Know

As the Simple Dollar notes, you will likely need to make a budget to figure out how to find extra money to pay down debt or save for retirement. I write about our anti-budget method here and whether it’s right for you. Whether it’s an anti-budget or a “regular” budget, find the tools that work for you, stick to them, and keep on using them. Have I said this point enough?

You might also be wondering, what’s up with the 7% cut off? 7% is roughly the rate of return that your retirement accounts will earn over time, so one can argue that it doesn’t matter whether you prioritize debt pay off vs investing at this juncture is the same.

Also, if you’d like a quick explanation on the debt snowball vs debt avalanche: the debt snowball will give you “quick wins” faster, because you focus on paying off the smallest debt first. With the debt avalanche, you pay less interest overall because you’re paying off the highest interest loan first, regardless of amount.

Final Thoughts

In the financial independence community, we often talk about working smarter, not harder, and optimizing every financial decision. People often lament not starting to invest earlier, even if they have lots of debt, for the reasons I shared earlier in this post. Don’t have that regret! By investing just a little bit in the beginning of your career, you’re giving future you money to look forward to after you’ve paid off all your debt.

A final note: debt pay off only works if you pick one strategy and stick to it. So while some strategies might save you more money than others, you need to know your own behavior and what motivates you. That said, if you’re dead set on optimizing this process to the nth degree, check out this comprehensive if-then framework from Listen Money Matters.