Lifestages: Pay Down Debt or Save?

I was recently posed this great question:  “Shall I pay down debt or save for retirement? Is there a ratio I should consider?” The short answer is yes. But, like all things planning, there are other considerations.

In this case, we assume you have a regular income and a budget with some cash left at the end of the month. The suggested savings ratio for a young professional is 10%-12% for all types of savings. As your age increases, so should the ratio until you are saving, at least 15%-20% of your gross income.

• These are the types of savings you should have:
  • Emergency fund – cash account to fund 3-6 months expenses
  • After-tax savings – investments
  • Retirement plans, including employer plans, IRAs and Roths

For the young professional, concentrate on building your emergency fund. When that is funded, start diverting to permanent savings. For retirement savings, if your employer offers a match on your contributions, contribute at least as much to receive the maximum match, typically 2%-6% of your gross income. Each time you receive a salary increase, increase your retirement savings by 1%. You’ll barely notice it and you’ll be building for the future. Now, stop and review, how much income remains after expenses?  These are the funds we will use to pay off debt.

• These are the types of debt in a payoff priority:
  • Credit card debt – pay off as soon as possible
  • Unsecured personal loans – pay off as soon as possible
  • Auto loans – depends on the interest rate
  • Student loans – may be beneficial to hold
  • Mortgage interest – may be beneficial to hold

List all of your debt, the balance outstanding and the interest rates. You may know your outstanding debt, but making a list helps visualize the problem. The prevailing wisdom is to pay off high-interest debt first, then personal and auto loans, keeping mortgages and student loans last due to their potential income tax advantage. One suggestion: if you have loans or credit card debt with small balances, pay these first. You’ll have less to track, and you’ll feel good about eliminating them.

If possible, never make interest-only payments on consumer debt, especially adjustable rate loans. Consolidation loans can be dangerous. Once you sweep your debt into one of these vehicles, there is nothing stopping you from running up the credit cards again. Instead, try to negotiate lower interest rates on credit cards, or transfer to lower interest rate cards, but read the agreements carefully. There are often balance transfer fees and late-payment penalties that make these choices less optimal.

Whatever your decisions, saving more or paying down debt faster, you deserve a pat on the back. You are doing it right!

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