9 Steps to Decide Whether You Should Pay Off Debt or Save for Retirement
Should you save for retirement or pay off debt? You can and should do both. Check out this step-by-step guide to help you figure out which is best for you.
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9 Steps to Decide Whether You Should Pay Off Debt or Save for Retirement

The personal finance question everyone is always asking: When you have extra money after you budget everything out, what should you do with it? Should you pay off your debt or should you start saving for retirement and pumping it into your 401k? 

Saving for retirement is one of the most important financial plans to put into action, even if the benefits you’ll receive can seem far in the future. Most financial experts say that savings should start as soon as possible, giving compound interest a chance to work its magic in the decades ahead.

However, most experts also say that paying off debt is essential for your current and future financial wellbeing. If like most people you’re carrying debt on credit cards, car loans, student loans, or a mortgage, which of these two pieces of advice should you take?

Clearly, there’s at least a little conflict between saving and paying down debt, especially if you’re on a tight budget. But deciding which one you prioritize is reasonably straightforward if you follow these simple steps to assess your own situation.


So, Should You Pay Off Debt or Save for Retirement? 

As with most things in finance, there’s no fixed answer to this question, as everyone’s situation is different. But in general, the earlier you can start your retirement savings, the more the effects of compound interest will mount up to increase the value of your investment. Saving even a little now each month can make a big difference by the time you retire.

What’s more, some of the most tax-efficient savings options have a limited contribution allowance each year. Once they’re gone, they’re gone, so taking advantage of them while you can is important.

But to set against these strong reasons to start saving early, if you have any debts, working to clear them more quickly also offers several clear benefits.


Benefits of Paying Off Debt:

  • Only paying the minimum on your debt will cost much more in interest over the long term, potentially canceling out the gains made on your investments.
  • As you make progress on clearing your debt, your credit score will likely improve, and you could get a lower interest rate on the balance that remains. Focusing on paying off debt can set up a virtuous feedback loop compared to treading water with minimum payments.
  • Paying down debt provides a clear road map ahead. You can calculate your results and track your progress every step of the way, unlike investments where economic fluctuations mean there’s always some uncertainty involved.
  • For many people, carrying debt is stressful, and clearing it more quickly can bring a better state of mind.
  • Lastly, living with debt can become a habit that’s hard to shake. If you don’t start clearing it sooner rather than later, no amount of retirement savings will compensate for large debts in later life.


In an ideal world, both paying down debt and saving for retirement would take high priority. But for most people, there will need to be a compromise between the two. Here are nine steps to help you decide on the importance to give each one.


1) Evaluate Your Financial Situation 

Before deciding on your strategy, you need to have a clear picture of how your finances currently stand.

A good start is to create a budget using the 50-30-20 rule.

  1. The first 50% of your income should cover your essential costs such as food, accommodation, transport, and so on.
  2. The next 30% can cover discretionary spending, such as entertainment and other ‘nice-to-haves’ which aren’t strictly necessary for day-to-day living.
  3. The remaining 20% is best used for a combination of paying down debt and paying into savings.


To work out how to split that last 20%, make a list of all your debts with their interest rates, minimum monthly repayments, and the total amount owed. Order the list with the most expensive high-interest debts at the top.

If your total debt repayments can be covered by the 20% you’ve set aside, then your plan will have a firm foundation. If not, can you change your budget around so it fits? Maybe you can increase your income or cut expenses until the figures stack up a little better, even if this means putting aside more than 20% of your income each month?

If your debt repayments total more than 20% of your income whatever you do, and particularly if they’re approaching 50% or more, then it might be a good idea to take some independent debt advice to see how your situation could be improved.

But ideally, you’ll now have a good idea of how much you can devote to your combination of debt repayments and savings.


2) Build an Emergency Fund 

Before setting up a savings and debt strategy, it’s important to start building an emergency fund. If an unexpected but essential expense crops up, for example home heating repairs or a new car transmission, then it’s best to have some quickly accessible funds available to deal with it.

An emergency fund will help you avoid building up expensive extra debt, or even worse, dipping into your retirement savings and losing the tax breaks you’ve already built up.

Even if you can only put a small amount aside each month, building up some fast-access cash in a regular savings account should be your first savings objective.


3) Make a Savings Start 

As well as building an emergency fund, it’s a good idea to start saving at least a small extra amount each month. Getting into the savings habit is important even if the actual figures aren’t that high just now, and compounding means that even small amounts will be worthwhile in the long term.

Consider starting with a basic savings account that’s separate to your emergency fund, and which doesn’t require too much maintenance or commitment while your savings are still relatively low.


4) Contribute to a 401(k) 

However, one particularly important form of retirement savings is a 401(k) plan, which you should probably start using as soon as you can, even if that means putting off dealing with debts. Many employers offer a scheme where they’ll match your contributions up to a certain amount each year, which effectively doubles your savings even before the tax breaks and interest benefits offered by the plan.

This high effective return means that a 401(k) makes better use of your spare cash than paying down almost any type of debt, so if you have the option available, contribute as much as you can.


5) Tackle High Interest Debt 

But now it’s time to take a look at your most expensive debts. If you have any debt with a rate above 10%, or one with a variable rate which could approach that level, then working to clear these will likely give much better returns than almost any investment.

For revolving debt such as credit cards, upping your minimum repayments will mean you clear a much higher proportion of the debt rather than just paying interest.

You may also be able to restructure your debts to reduce their costs. For example:

  • Refinance student loans to get a lower rate, bearing in mind that refinancing federal loans to private ones will lose you some valuable protections.
  • Consolidate credit cards and personal loans into a larger loan with a lower interest rate.
  • Transfer credit card balances to a new card with a lower, or zero, interest rate.


6) Find an Effective Debt Repayment Plan that Motivates You 

Restructuring debt can reduce the overall interest burden, but it’s still important to put together a solid repayment plan to clear the balance as efficiently as possible. A good plan should have two parts. First, it should make inroads into your total debt by clearing the most expensive ones earliest. Second, it should show clear results that keep you motivated, rather than feeling you’re in a long struggle with no end in sight.

A method known as the debt snowball is one of the best ways of combining these two ideas. To use it, take all your expensive debts which you need to clear first, and set up minimum payments on each one.

Pick one of the smaller debts, and concentrate all your extra repayment fire power on clearing it as fast as possible, using every dollar you can spare. As you’ve chosen a smaller debt, you should see rapid progress in reducing the balance, and you’ll also receive a psychological boost when it’s cleared.

But the crucial aspect of the debt snowball is that once the first debt has been cleared, you should pick the next smallest one, and add the repayment from the first debt to the existing repayment on the second. This sudden increase in repayment amount will start to drive the debt down more quickly, maintaining the psychological motivation as visible progress is made.

Continue the process, and by the time you’re down to the last debt, your monthly repayments will have grown to a size where they make a real and immediate impact on even your largest balance.

Other repayment methods can also work well, with some people preferring to focus on the most expensive payment first, so that the reduction in monthly costs can happen sooner. But the important point is to pick a method that works to reduce your overall debt, but also shows enough progress to stop you getting discouraged.


7) Examine Lower-Rate Debt 

If you have other debts with a lower rate, are they costing you more in interest payments than you could earn through investment? If not, it doesn’t make a lot of financial sense to concentrate on clearing them instead of saving for retirement.

For example, if you have student loan debt that costs an average of 4.5%, your money will work harder if you put it in an investment averaging a 6% return. For debts like these, it’s usually more effective to stick to the original repayment schedule, and divert any extra cash in your budget into savings.


8) Should You Pay Off Your Mortgage or Save for Retirement? 

The same thinking applies to paying off the money you owe on your house. Mortgages are among the least expensive type of debt around, and unless your mortgage has an unusually high interest rate, it’s often better to use any slack in your budget to save for retirement rather than paying off your home a few years earlier.

However, for some people the psychological benefits of clearing such a large debt can be significant, so it’s important to find your own balance for each individual debt.


9) Ramp Up Savings 

Once your most expensive debts are under control and you’re starting to see some leeway in your budget, you can start to steadily ramp up the amount you save. The general recommendation is to save around 10-15% of your annual income for retirement, so until you’ve hit this figure, retirement savings tend to make more sense than paying down less expensive debt like student loans or a mortgage.

But always remember that compounding is extremely important for retirement planning.  If you’re unsure whether your money is best used for paying off a cheap debt or investing, retirement savings should probably take priority.


Conclusion: Paying Off Debt vs. Saving for Retirement 

In an ideal world, both clearing debt and investing for retirement would be high priorities. But in real life, few people can do both as much as they’d like.

Putting together a plan that fits your situation means:

  1. Getting started on some level of savings if possible, particularly a 401(k) or other tax-efficient plan which gives good long-term returns.
  2. Making headway on your most expensive debts to reduce the drag they have on your finances.
  3. Putting any extra money where the figures show it will have the most effect, whether that’s clearing lower-cost debts or investing for the longer term.


But the most important point to remember is that no two situations are exactly the same. Your savings and debt strategy should be one that best works for you, rather than following a fixed formula found online and aimed at a general audience.