Because paying off debt and saving for retirement are two of the largest financial moves you’ll make in life, figuring out how to best pay for them warrants thorough examination. In order to answer these questions wisely, we’ll look at the math first, and add a dose of reality second. To understand the math, let’s take a trip down memory lane to high school math class and review the differences between simple interest and compound interest.
Simple interest vs. compound interest
Whether you’re saving, investing, or taking out a loan, there’s always a principal amount and an interest rate that can be used to calculate the interest accrued. The principal amount is the amount you borrowed on a loan, or the amount of money you’ve invested. When you multiply the current principal amount by the interest rate, and multiply that by how many years it grows, you can calculate how much interest has accrued for a loan or investment with simple interest. Simple interest grows linearly over time.
Compound interest can either be your best friend or your worst enemy depending on whether you’re on its good side or bad side. Because compound interest is an exponential function, it begins a steep climb that only gets steeper and steeper over time. The reason compound interest grows much more quickly than simple interest is because with compound interest, you are paying (or gaining) interest on the principal amount and on the interest already accrued in the past. It’s almost as if the interest gained on the loan so far gets added to the principal amount, which is then multiplied by the interest rate to determine the interest owed. With simple interest, you are only paying (or gaining) interest on the principal amount.
Applying simple interest and compound interest to real life
Therefore, if you are paying off a loan, it’s in your best interest as the borrower that the loan gains simple interest. With simple interest, you will owe less over time than with compound interest. If you’re sitting on the other side of the table and you are a lender looking to make interest off of money you lent out, then it’s in your best interest that the money you are lending gains compound interest. As a lender, you stand to make more money in interest with compound interest over simple interest.
If you have credit card debt, compound interest is working against you because the amount of money you owe grows at an exponential rate. You’re not only paying interest on the original amount you borrowed, but also on the interest you’ve already been charged. If you’re investing in a 401(k), then compound interest is working in your favor. The more money you put into your 401(k), the faster it grows. Each time you put money in your 401(k), you’re increasing the amount of money that you’re gaining interest on, and therefore, you gain more and more interest over time.
The bottom line is that you want compound interest working for you (e.g., 401(k) investments), not against you (e.g., credit card debt).
Paying off debt vs. saving for retirement
To find out whether you should pay off your debt or save for retirement first, answer these two questions:
- Do any of your debts have compound interest?
- Do any of your debts have an interest rate higher than 7%?
If you have credit card debt, you will likely answer “yes” to both of those questions. Because credit card debt typically compounds and has very high interest rates, it grows very quickly and is difficult to pay off. Since you never want compound interest working against you, it’s best to pay off credit card debt as fast as possible, and avoid it altogether in the future. You can put all the money you can toward credit card debt before thinking about saving for retirement and know you’re making a smart move.
If you only have student loans, or maybe a car loan, hopefully you’ll answer “no” to both questions. Student loans and car loans generally have simple interest, which is much easier on you as a borrower than compound interest. Because the average stock market return over time is 7%, you can use that 7% to estimate the growth of your retirement investment and compare that rate to the interest rate on your existing loans.
For example, if you have student loans with simple interest ranging from 3% to 6%, and you can estimate that you’d be making 7% compounding interest off of your retirement investments in the long run, then you should definitely be investing in your retirement because you will be making more in retirement savings than you would be losing in debt. In this scenario, you will make the most money over time by investing in your retirement. That’s because you will be making more money with gains in your retirement account than you will be losing on interest gained on your debt. If you did the opposite and put all of your money toward paying off your student loans, you would be losing out on potentially large gains from your retirement account.
If you have a loan with simple interest around 12% and you invested in your retirement, it’s more difficult to tell where you should be putting your money. Initially, it will be a better idea to put money toward your 12% simple interest loan than toward retirement since you’ll be saving more money by paying your loan than by investing in your retirement. However, because your retirement savings compound, eventually the scenario would switch, and it will be a better idea to put more money toward your retirement than toward your 12% simple interest loan. With the compounding effect of 401(k) accounts, eventually you would be making more money by investing in retirement than you would be saving by paying off your 12% simple interest loan.
If you want to do this comparison calculation with your own loans, you can use a simple and compound interest calculator to compare the interest accrued on your loans with the estimated interest you would gain from investing in your 401(k).
The bottom line for balancing debt and retirement
- Regardless of what debt you have and whether or not you’re investing in your 401(k), the first step to being a savvy personal financier is to create an account buffer. An account buffer not only protects you from overdrafting your account but is also like a mini emergency savings. While it might be tempting to put all of your extra money toward paying off your loans and investing in your 401(k) rather than having it sit in your bank account, it’s not the wisest move. Make sure you save up a solid account buffer to protect you for when life happens.
- If you have any debt with compound interest, such as credit card debt, it’s best to pay that off before thinking about retirement savings. You never want compound interest working against you.
- As long as you have loans with simple interest less than 7% and are able to pay at least the minimum payments on those loans, it’s smart to put a consistent percentage of your income toward your 401(k) to reap the benefits of compound interest. The sooner you start investing in your 401(k), the more powerful the effects of compound interest will be.
- If your employer matches your 401(k) contribution, always max out that match—it’s basically free money, and even more reason to invest in your 401(k).
- Because investing in your 401(k) is investing in the stock market, and investing in the stock market can be risky, it’s smart to still pay more than the minimum payment on your simple interest loans in addition to contributing to your 401(k) if you can afford it.
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