How to Save Money on Retirement by Getting Out of Debt
We all want to reach the point where we don’t have to work to earn our living. We want to relax and enjoy life without any financial difficulties. Of course, this won’t happen if you don’t save for retirement. But how can you save money if you have debts? There are several things to consider when trying to balance retirement savings with debt repayment.
We’ve already asked how you combine saving and paying off debt before. This is a complex question that depends on many factors. Here’s what you need to consider.
First things first: create an emergency fund
Before you think about investing money or paying off a debt, make sure you have a contingency fund .
It seems counterintuitive to build up savings while you are in debt, but this is an important step to avoid falling into the debt trap . So accumulate a small amount of savings while paying the minimum debt payments at the same time. Most experts recommend saving at least three months on living expenses, but even a few hundred dollars is better than nothing.
When I was getting out of debt, it would take me forever to save on three months’ expenses, and I wanted to get out of debt quickly. At first, I tried to do without the reserve fund altogether. It didn’t go so well. When an imminent emergency arose, I wrote it down on a map and my debt was immediately canceled. So I compromised and saved $ 1000 for an emergency. It wasn’t nearly as much as the experts recommend, but it was enough to pay for small setbacks without undoing the growth in my debt. But I also had an emergency plan : return to my family (who would have preferred me to stay at home anyway). So I had options for each scenario.
At Bankrate, personal finance author Paula Langgut suggests systematically saving and paying off debts by setting milestones. For example, once you reach $ 500 in your emergency fund, increase the minimum debt payment by a certain amount, and then reduce your savings in the emergency fund. Increase your payments by $ 2,000, reduce your savings even more, etc.
Take advantage of a 401 (k) match
So you’ve saved up for an emergency and are making the minimum payments on your debt. If you’re fortunate enough to work for a company that matches your 401 (k) fees, it’s time to take advantage of that .
After all, this is free money. Let’s say your company is half of what you contribute to your 401 (k), up to 6% (a fairly common scenario). This is a guaranteed yield of 50% . You won’t get it anywhere else, so don’t miss it. This rule is pretty much universal for anyone with a 401 (k) match, regardless of your age or debt.
Of course, since this is free money, some people may be torn between taking advantage of the match and saving for an emergency. Just remember: the emergency fund is there to protect you. If you run into financial trouble and nothing is saved, you may be forced into even more debt. You can take money from your 401 (k), but then you will pay a fine. It is best to have a small pillow for money.
But what if you can’t afford a match? Here’s what money under 30 offers:
But even if this type of contribution is squeezing your budget, you can always choose to contribute 4 percent of your salary to get 2 percent employer match, or even 2 percent of your paycheck to get 1 percent employer match. … Sometimes the tap does not need to be turned off – you just need to lower it to a trickle. If you can do this by prioritizing debt payments, you will eventually come out ahead.
In short, use this as much as possible. This is another mistake I made while paying off the debt. I prioritized my debt goal and it was awesome, but I also missed the 401 (k) match at first. I figured I couldn’t “afford” to save for retirement because I was in debt, so I essentially gave up the spare money from my employer.
Find out which goal is more important
After setting up an emergency fund and agreeing to free up the money, the balance between paying off debt and saving isn’t all that black and white. Debt is almost always the highest priority. But ask yourself the following questions to figure out how to prioritize retirement.
How close are you to retirement?
As you approach retirement age, savings will take precedence. The amount of savings will also depend on your income, debt payments, and how close you are to retirement.
Personal finance writer Ramit Sethi says there are three ways to think about how to prioritize:
- The mathematical answer is to put your money where it will have the greatest impact. If the interest rate on your debt is lower than the interest rate you can expect from investing, pay the minimum on the debt each month and invest the rate.
- The emotional answer is that many people hate to have any kind of debt, so even if they pay off the debt at low interest rates, it still makes sense to them.
- A hybrid approach is to split the difference: pay off some of the debt and invest some. Nice compromise.
Most people automatically lean towards the mathematical answer that makes the most sense on paper. But personal finance has a lot to do with thinking, which is why Sethi offers a hybrid approach. This may be the best compromise if you are nearing retirement age.
As practice shows, you should save 10% of your income for retirement, but this is not always possible. If you are playing catch-up, you may need to contribute as much as possible. Use the retirement calculator to determine where you should be and how much you need to save to get there.
However, you still want to retire as debt-free as possible. So whichever approach you choose, getting rid of high interest debt should still be a priority.
What is your debt?
Add up all your debt and look at your interest rates. Forbes author Laura Sheen suggests :
Write them down in a spreadsheet from highest interest rate to lowest interest rate. Include everything from credit cards to car loans and mortgages and student loans. This list will be helpful when trying to prioritize debt repayment over the potential growth of your pension contributions.
If your interest rates are incredibly low (for example, say you have a car loan at 0%), you can probably put it off while you do it. Pay the planned monthly payments on the debt, but then use your additional income to save.
And there is also a mortgage. It’s tempting to pay off your mortgage ahead of schedule , but most experts recommend focusing on accumulating funds for retirement first. As good as it may be to recoup your home, you want to use the time when it comes to investing – you will come out ahead in the long run. Financial guru Dave Ramsey suggests investing 15% of your income into retirement before you start working on increasing mortgage payments.
But if you have high interest revolving debt, such as a credit card, that should be your first priority.
As a rule, financial planner Sofia Bera recommends solving any debt with an interest rate of 6% or higher. This advice is likely based on a general assumption of an average market return of 7% – if you have less than 6% debt, you will probably do well by prioritizing your investment. So, if you are dealing with debt below that, you may want to consider focusing on retirement. Of course, if you are dealing with multiple debts, you need to add up all the interest you pay on your total debt each year and compare it to how much savings you could have earned for retirement.
Do the math and make sure you are not paying more than you could have made a profit.
What does your loan look like?
You can also focus on debt if you are trying to improve your credit score.
Credit usage is 30% of your FICO score . This is basically the amount of credit you are using versus the amount you can use. The lower your debt to credit ratio, the better your score.
If you are trying to get a mortgage or buy a car, you may have to prioritize debt in order to improve your credit.
In general, it all comes down to numbers. You can help achieve both goals at the same time, but you should at least know which one is the priority. Once you’ve done that, come up with a plan.
A budget for both purposes
We will assume that you have a basic budget to account for your living expenses and additional expenses. After that, you’ll want to decide how much of your income to invest in debt, and then how much you can afford to throw away when you retire. Shin offers advice :
- Calculate how much money you can spend on your financial goals after setting up your core budget.
- Add up the minimum payments for all your debts.
- Subtract # 2 from # 1.
- Decide how much to allocate for each goal. If you have high interest debt, you probably want to set aside 100% now. For all other debts, adjust the interest rate based on the above factors.
Again, you might consider setting a savings target and then increasing debt repayment as you achieve that savings goal. Or vice versa: after paying a certain amount of debt, you can decide to increase your pension contribution.
Both getting out of debt and saving for retirement are important financial milestones. Combating them at the same time can be challenging to achieve balance. Analyzing your situation and drawing up a plan will help you come to a compromise and ensure that you make the smartest financial decision to achieve both goals.