When it comes to saving for retirement, the earlier you get started, the better. With each passing year, the amount you need to save annually for a comfortable retirement increases. And with an economy that is showing no signs of improvement, planning for your future has become more important than ever.
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But as important as it is to start saving for retirement early, you may be better off tackling your consumer debt first. In some cases, the amount of debt you have not only affects your budget today, but it can significantly limit your options in the future. So if you're contemplating whether to pay down your debt or save for your retirement, here are three reasons that paying down your debt first may be the better option.
The interest rate on your debt is higher than investment returns
Unless you've found some secret, no risk portfolio with a return of 10 percent or greater, the debt you currently have is most certainly costing you more interest than you could earn by saving for retirement. Most diversified stock portfolios are unlikely to return more than 10 percent, and that's not even considering the risk that stocks always present. And high-interest savings accounts and CDs are currently offering extremely low interest rates. The interest rates on savings accounts and CDs are continuing to fall at an alarming rate. As it currently stands, the best you can do is right around 1 percent for savings accounts and 2.5 percent for a long term CD. Instead of taking $10,000 and earning $100 a year in interest before taxes, take that money and pay off high-interest debt.
Paying down debt will increase your credit score
By paying down your debt, you will over time improve your credit score. And a higher credit score can save you a lot of money down the road, particularly if you plan to buy or refinance a home. Paying down debt reduces your debt to credit ratio, which is a key factor in calculating your FICO score. While there are a myriad of factors that determine your credit score, one of the biggest is just how much debt you already have. Increasing your credit score now will open the door to future credit opportunities as well as the potential to reduce current interest rates on outstanding debt. And a good credit score can even lower your car insurance premiums.
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Your employer doesn't offer a 401(k) match
Some employers will match contributions that employees make to their 401(k) retirement accounts. If you're one of the lucky ones who have this benefit at work, paying off all your debt before saving for retirement may not be a great idea. Why? Because you’d be passing up some free money for your retirement account. But if you employer does not offer matching contributions, then scale likely tips in favor of paying off your debt. It's true that a 401(k) offers some tax advantages (taxes generally are deferred until retirement), but this benefit usually does not offset the downside of carrying high interest consumer debt.
It's a great feeling when you see your debt going down month after month. Dave Ramsey has built a career out of his debt snowball, in which you wipe out your debts from smallest to largest, simply to cross them off your list for motivation. So take your extra money each month and apply it to your highest interest debt, and you'll find that not only is it the smart move, but also a satisfying one.