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Pay Down Debt or Increase Savings

A friend of mine who is early in his career recently told me that he had finally paid off his car. He wanted to know whether he should use his newly available cash flow to pay down other outstanding debt or use the funds to increase his retirement savings. This is a good question. In this post I will provide my thoughts on this topic.

For many people early in their careers, there comes a time when they finally can save money from their monthly income. Since most young people still have significant debt outstanding such as school loans, a home mortgage, a home equity line, a car loan, etc., there is a dilemma of whether to apply their monthly savings toward outstanding debt or save for retirement. Everyone’s situation is different and may call for different approaches.

My first advice to anyone of working age is to set aside at least 3 months and preferably 6 months living expenses in an emergency savings account. These funds should be set aside as insurance again an unexpected job loss. If your job situation is tenuous and you would not be able to easily find a new comparable job, then your emergency savings account should be larger. These funds should not be used for one-time predictable costs such as a new roof or furnace for your home or a new car. A separate savings account should be set up for these items.

In general, the younger you are it is better to apply your monthly savings toward retirement accounts. The reason for this is that the earlier you start your retirement savings plan, the smaller the monthly contribution required to reach your retirement goals will be. This previous post illustrates the cost of waiting to start your retirement savings plan. Also if your employer offers matching funds in their 401(k) plan, you certainly do not want to pass on this free money. Contributing enough money to capture 100% of your company matching funds, if available, should be the minimum you contribute to your company retirement account each year, regardless of how much other debt you have.

Another factor that should be considered in deciding where to direct excess monthly income is the type of debt you have. If all your debt is of the amortized fixed rate kind, then all your excess monthly savings should go to your retirement savings. However, if you have any debts that carry adjustable interest rates such as a school loan or a home equity line, I would try to convert these loans to a fixed rate. If this is not possible, I would dedicate a larger amount of your savings to pay down these loans. The reason for this is that we are currently experiencing the lowest interest rates in a generation. These low rates are not likely to last. If interest rates increase, your monthly payments will increase eating up an even bigger portion of your monthly savings. I feel so strongly about avoiding adjustable rate loans that, if your current home mortgage loan has an adjustable interest rate and you cannot re-finance it to a fixed rate loan, I would sell your home.

Anyone that has debt with adjustable interest rates (other than their home mortgage loan), and will not be able to pay it off for several years, should dedicate half their monthly savings toward retiring this debt. The other half should be added to retirement savings. Once the adjustable rate debt is paid off, then all your savings should go toward retirement accounts.

For funds that you can dedicate to retirement savings, this is the priority I would use:

1. First contribute enough funds to your employer 401(k) to capture your employer’s matching funds, (if your employer’s 401(k) plan allows Roth contributions as well as tax deductible contributions, you should split your contributions evenly between the two).
2. If you have additional money you can save (assuming you do not have a Roth 401(k) option), I would add these funds to a Roth IRA if you qualify (in 2012 your Adjusted Gross Income must be under $110,000 for single people and under $173,000 for a married couple),
3. If you still have additional money you can save, I would go back and continue adding to your employer’s 401(k) plan until you reach the 2012 limit ($17,000 per person if you are under 50 years old or $22,500 if you are 50 or old),
4. By chance if you still have funds to invest, I would add more money to your emergency fund. When your emergency fund equals about 12 months of living expenses, I would open a brokerage account and begin adding to stock equities outside your retirement accounts.

This savings approach allows you to begin creating a retirement savings plan that includes tax-deferred, tax free, and taxable retirement accounts. This provides your retirement assets with tax diversification which will help you minimize your taxes while in retirement.

Everyone’s situation is different, so it is not possible to give one size fits all advice on this subject. However, I would use this discussion as a general guide to deploying your available savings.

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