When you first get started managing your personal finances, many people are faced with an intimidating to-do list. You need to make a budget, create an emergency fund, reduce debt, get insurance, buy a house, invest, save for retirement, and save for your children's college costs. It's hard to know where to start. Oftentimes people give up or get stuck deciding between these big goals. One especially tricky choice is deciding between retirement savings or debt reduction. Should you delay your retirement savings until your debts are paid off?
The decision, of course, will depend on your particular situation. It’s called personal finance for a reason. Here are some factors to consider as you decide whether to allocate your paychecks to past debts or retirement savings.
The type of debt. Generally speaking, the higher the interest rate you have attached to your debt, the more likely it is that you should focus on paying down debt prior to starting retirement savings. High-interest credit card debt or personal loans should, in most cases, be paid off prior to aggressive retirement savings. The stock market isn't going to return more for your money than you are currently paying out on your high-interest debt. So, it’s in your best interest to get rid of the debt first. If, however, your debts are not incurring high interest charges, then it makes sense to pay the minimums and focus on retirement savings.
Your income and spending situation. If you fear you might lose your job or if you have major expenses coming up, then you might need to focus on your short-term finances. Paying down debt frees up money that can be used for emergencies. If you plan on making a major purchase such as a house or car, paying down debt could improve your credit score, resulting in a more favorable loan. Also consider your propensity to get into more debt in the future. You need to create an emergency fund so a new unexpected expense doesn’t cause you to go into debt again.
Your retirement account options. If you have access to a 401(k) at work and your employer matches a percentage of your contributions, then you should lean towards getting that money before you pay off debt. It's hard to beat the return that matching provides. Also factor in any tax breaks you become eligible for by saving for retirement. If, on the other hand, your company is not matching or only matching with company stock, then consider focusing on debt first. The match might not be worth it if you are required to overload your portfolio with one stock.
Of course, you don’t necessarily have to choose one or the other. You may be able to pay down debt and save for retirement at the same time if you’re willing to take steps to reduce your current spending or seek ways to increase your income.
Philip Taylor is the author of 104 Ways to Save Extra Money. Read his popular blog, PT Money: Personal Finance for more insightful money tips, like his recent suggestions for the best online checking accounts.