Should I Save for Retirement or Pay Down Debt?

In a recent post, I provided some practical tips for setting financial goals. Let’s be honest, setting goals is hard. And actually putting together a plan (and carrying it out!) to reach your goals is even more difficult. But to further complicate things, what happens when you identify goals that seem to be in direct competition with one another?

“Should I save for retirement or pay down debt?”

This is a question I frequently receive and to be honest, I typically shy away from making general recommendations. In fact, I don’t think “one size fits all” solutions exist when it comes to financial planning. But if you find yourself wondering how to balance these seemingly competing goals, allow me to suggest the following steps as a starting point.

1. Create an initial, emergency reserve
The first thing you should do is understand what you need to live on each month. In other words, how much income is necessary to pay your essential bills (i.e. fixed expenses)? While continuing to make minimum payments on your loans, you should save one month of living expenses to a bank account. Don’t invest it as you want to be sure you may easily access the money in case of an unforeseen emergency or job loss. I refer to this as the initial, emergency reserve.

2. Make a list of your loans
Once you have an initial, emergency reserve, it’s time to take inventory of your loans, excluding your mortgage.  Examples of such loans may include credit cards, auto loans, and student loans. Write them down and order them from the highest to lowest interest rate.

Continue making minimum payments on the loans with the lowest rates, but begin applying every available dollar towards the balance with the highest rate. (Side note: Some advisors recommend paying off the loans with the smallest balance first, simply to “gain momentum.” While it’s nice to pay off those small loans, I prefer you pay off the highest interest rate loans first to save yourself money in the long-run). Once you’ve paid off the loan with the highest interest rate, cross it off the list and apply the money you were paying on it to the next loan. Continue this process until your non-mortgage debts are gone. The “snowball” effect of applying each loan payment to the next loan on the list will enable you to pay them off as quickly as possible.

3. Fully fund your emergency reserve
Once your loans are paid off it’s time to circle back to your emergency reserve. Typically, having one month of living expenses in the bank isn’t sufficient. Each person’s comfort level will vary, but I generally recommend you target six months of living expenses for a fully funded emergency reserve. In other words, if you need $5,000 per month to meet your standard of living, you should aim for $30,000 in your emergency reserve.

Take some time to contemplate this decision though as you may be comfortable with less or more in your emergency reserve. Regardless of how much you decide is appropriate for your situation, be sure to save what you were making in loan payments toward your emergency reserve each month. This will continue the “snowball” effect and enable you to fully fund your emergency reserve as quickly as possible.

4. Save for retirement
Depending on your income level and expenses, steps two and three make take a long time to accomplish…sometimes years! Moving forward in this order, however, sets a solid foundation as you begin planning for the future. Once your debts are paid and emergency reserve funded, begin saving for retirement!

It’s important to reiterate everyone’s situation is different. In some cases, it may make sense to reverse steps two and three. In other situations, particularly those that may be eligible for a generous employer matching contribution to a 401(k), it may be wise to pursue step four in tandem with steps two and three. Remain flexible and take some time to consider your unique situation. Follow the steps outlined above and you will position yourself to succeed financially!