When meeting with clients to determine the most efficient ways to maximize retirement savings, it’s not unusual for me to come across debt in a portfolio which prompts the million dollar client question, “Is it better to use my income to pay off debt or save for retirement?” While it’s typically best to pay off bad debt first, not all debt should be treated equally.
The trick to knowing when to prioritize debt over savings vs. savings over debt lies in whether it’s “good debt” or “bad debt,” as well as the interest rate associated with it.
Bad Debt - Any money you borrow to purchase a depreciating asset (cars, clothes, vacations, goods and services) isn’t worth adding to your debt. The worst offender is credit card debt because it typically has a very high interest rate.
Good Debt - Any loan you take out in order to increase your net worth or generate income (like student loans, small business loans or real estate) is worth going into debt for and can generally be paid off slowly over time at a reasonable interest rate.
You should also approach your debt payments strategically. For example, if you have a mortgage loan at 4% interest and your investment accounts are earning 6%, you should let your accounts ride and pay off your mortgage over time. But if you have credit card debt and are paying an interest rate at 14%, it would be extremely beneficial to pay off the credit card first before making more contributions to your investment accounts.
It’s always important to note that living within your means makes credit card debt less likely and allows you to invest more money. How you manage your debt today plays a significant role in your retirement dreams, so if you’re unsure about whether or not to pay off a particular debt, let’s find some time to talk it through.